by Nick Anhut, Senior Municipal Advisor,
Greg Johnson, Senior Municipal Advisor,
and Jeff Seeley, Senior Municipal Advisor

Alternatives to Refunding

Municipal issuers have historically enjoyed the privilege of being able to optionally redeem existing, long-term debt at face value during the life of a debt issue. For most debt with final maturities 10 – 20 years in the future, this “par call” feature can typically be exercised on and after about years seven through ten, depending on the structure and term to final maturity of the issue. The most common method to redeem prior debt obligations has been to issue new debt to refinance (or “refund”) those prior issues to achieve debt service savings. These savings are normally attained through either lower interest cost debt matching the same term as the refunded issue with reduced payment requirements or retiring debt more rapidly with the same payment requirements.

In normal interest rate environments, issuers enjoy the “roll down” effect of a positively sloped yield curve. Typically, there is what’s referred to as term premium embedded in a borrower’s cost of capital. All else equal, lenders and investors require additional return as the term of a financing increases. In general, the longer the maturity of the debt, the higher the interest rate. As time elapses, what was a 15-year maturity becomes a 5-year maturity, which presumably would now carry a lower rate provided the general level of interest rates hasn’t increased materially.  Clearly, we can all agree that other than a few brief interludes, the last 15 years have presented anything but a normal interest rate environment.

A general benchmark for long-term borrowing costs is the 10-year U.S. Treasury. Ten years is close to the average life of a 20-year financing with level payments (it’s about 12).  From mid-2011 through mid-2022, the 10-year Treasury rarely breached a yield of 3.00%. For a large proportion of that time, it was under 2.00%. During that period, many municipal bonds were issued with callable maturities that carried coupons of 2.00% to 4.00%. Additionally, the current interest rate environment is one that exhibits a rather flat and even inverted yield curve (overnight rates exceeding longer-term rates). U.S. Treasuries maturing in one year yield a little over 4.00% and 4.40% at ten years – a difference of only 40 basis points.

A rule of thumb as to whether an issuer can achieve savings through refunding is current yields need to be roughly 150 basis points (1.50%) lower than the coupon on the existing debt (higher if shorter in term and smaller in dollar amount). With callable debt issued during a time of ultra-low rates and today’s flat yield curve, refunding prior debt for savings is difficult to achieve and, in some cases, may never be feasible. This isn’t a new phenomenon, which is borne out by statistical information. According to The Bond Buyer’s published data, the most recent peak in refunding activity occurred in 2020 when over 50% of new issue volume was for the express purpose of refinancing. In 2024, roughly 11% of total volume was wholly related to refunding, and less than 10% through May of this year. Unless interest rates decline precipitously, and even if the Fed reduces overnight rates, it’s unlikely this paradigm will change any time soon.

As they say, you have to play the hand you’re dealt. So, when refinancing for savings is not a viable option, how might issuers find ways to extract savings from their existing debt portfolio?

Minnesota Municipal Issuers

Minnesota municipal debt issues carry some unique characteristics. One prominent feature is the statutory requirement to levy 105% of annual debt service.  Another common element is financing infrastructure costs that are assessed to benefiting property owners.  Both circumstances can lead to balances accumulating in the debt service fund for the issue. Let us first state the obvious that this is undesirable from a tax compliance perspective (not applicable to taxable obligations). The levy each year for general obligation debt should be an amount net of any balance available in the debt service fund. To the extent balances do accumulate, they can and should be applied to the principal outstanding of a debt issue that is currently callable. In these cases, the issuer should understand that any callable maturity can be optionally redeemed in full or part, with the highest coupon maturities being the priority.

For those issuers that more actively manage their debt portfolio and available cash resources, especially those with larger semi-annual payment requirements, a strategy that captures a positive “carry” can have benefits. As taxes are received that are then deposited to a debt service fund to meet subsequent payment requirements, those funds can be invested until needed. With investment rates out to one year presently over 4.00%, the interest earned can be more than interest paid.  Any excess after all annual payments are made can then be used to reduce the following year’s levy requirement. This exercise can provide benefits even when investment rates are less than coupons on existing debt but is clearly far more advantageous with some of the highest short-term rates in many years. Issuers should be careful to maintain bona fide status for debt service funds associated with tax-exempt obligations subject to arbitrage rebate under this approach. Also be sure that any investments made from balances in a debt service fund comply with the applicable statutes.

Wisconsin Municipal Issuers

Issuers should regularly monitor their reserve balances and determine if amounts in excess of policy or other parameters should be deployed for tactical purposes. Careful consideration should be given, as one hasty decision today can lead to years of challenges in the future. A long-term strategy grounded in policy should always be established when using precious resources like available fund balances.

It’s considered a best practice to prepare a multi-year capital improvement plan (CIP).  Projects in a CIP are funded in various ways, including a pay-as-you-go approach, applying available reserve balances, and borrowing.  If a governmental entity regularly issues debt to fund its CIP, further analysis is warranted when reserve balances might be available for capital expenditures. While it might seem tempting to use available reserves to reduce debt outstanding, you might be missing the bigger picture. It’s reasonable to assume that the cost of borrowing today is likely higher than the rate of some of your debt outstanding that’s subject to call and prior payment. Applying that cash to today’s capital projects might provide the most efficient economic outcome and still achieve the greater objective of reducing debt outstanding.

Under a mildly different approach, cash balances could be assigned for debt retirement and then invested in a targeted manner to potentially “outearn” the interest cost of maturities of existing debt at current investment rates that are higher than the corresponding coupons on those maturities. The net interest earned would be retained in the respective fund.  An important aspect of this scenario is to assign the money within the fund and then transfer to the debt service fund at the appropriate time, rather than initially transfer to the debt service fund. There may be a wider universe of allowable investment options outside of a debt service fund; and, once the monies are deposited to a debt service fund, they typically can’t be removed. If for some reason circumstances change, the plan can also be adjusted and reserve balances retained, provided those dollars have not been transferred to the debt service fund. This tactic can be done in a targeted and specific fashion, including multi-purpose issues that have various repayment sources like utility and TIF revenues. As mentioned previously, most debt subject to optional redemption is pre-payable in full or part.

School District Issuers

It’s common practice when refinancing debt for savings to refund the entirety of the prior issue, leaving only the new debt in its place. As stated above, it’s important to reiterate that most debt currently subject to optional redemption need not be redeemed in full. It’s certainly possible to refinance specific maturities of an existing debt issue for savings, while leaving the rest of that issue in place without impacting the ability to prepay the remaining amount in the future.

Partial refundings have become far more prevalent. In fact, earlier this year, Ehlers assisted a school district with evaluating its options related to two outstanding debt issues that were currently callable. Ehlers recommended a refunding issue that combined eight maturities comprised of both prior issues out of the 18 that were callable. The refunding resulted in over $3 million in savings, and the district preserved its ability to refund or pre-pay the remaining maturities at the most opportune in the future.

Also, the underlying circumstances associated with the original plan of finance change over time. An issuer may be able to levy taxes at the same rate against a larger tax base, producing a higher amount of property tax revenue. In turn, the larger tax collections can allow for a more rapid debt amortization, even if rates on new debt are roughly the same as the old.

While the traditional method of producing savings on existing debt by refinancing may be hibernating for the foreseeable future, there’s more than one way to achieve a similar outcome. However, most alternatives require a higher level of planning and strategic thinking and may not produce quite as much bang for the buck. Policy prerogatives can and should be your guiding star in this regard.

With some foresight and analysis, your jurisdiction can potentially extract some budget savings or revenue enhancements with a prudent approach.  Ehlers’ Advisors are always available to discuss your specific situation and provide guidance on positive outcomes for you and your constituents.

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