What Is a Pre-Refunding Link?
A pre-refunding bond is a debt security that is issued in order to fund a callable bond. With a pre-refunding controls, the issuer decides to exercise its right to buy its bonds back before the scheduled maturity date.
The proceeds from the exit of the lower yield and/or longer maturing pre-refunding bond will usually be invested in Treasuries (T-bills) until the listed call date of the original bond issue occurs.
Key Takeaways
- A pre-refunding bond is issued by a corporation with the wittingly b especially of funding a callable bond at a later date.
- Pre-refunding is a strategy used by corporations to effectively refinance their owed debt.
- In the interim period between the initial issue and the subsequent callable bond issue, proceeds are held in secure Treasury securities.
Pre-Refunding Bonds Explained
An entity that is scheduled to call its existing bonds on a specified get date can choose to issue new bonds of which the proceeds will be used to fulfill its interest payments and principal repayments on the persisting older bonds. The new bond that will be issued for this purpose is referred to as a pre-refunding bond. Pre-refunding links are typically issued by municipalities, and are secured by high credit-quality investments. The new bonds are known as refunding bonds, and their proceeds are occupied to pay off the older bonds, referred to as refunded bonds. The refunded bonds are paid off at a predetermined date, hence, the term “pre-refunded” trammels. Using pre-refunding bonds can be a good method for issuers to refinance their older bonds when interest rates diminish.
A callable bond is one that can be “called” or repurchased from the secondary market by the issuer before the maturity date of the agreement. When interest rates in the economy drops, bond issuers have an incentive to repurchase existing bonds which entertain higher affixed interest payments, and issue new bonds at the lower interest rates in the market. This reduces the issuing article’s cost of debt in the form of lower coupon payments to bondholders. However, to encourage investors to purchase callable constraints, these bonds usually have a call protection which prohibits the issuer from calling the bonds for a particular period of time, say five years. After those five years, the entity can exercise its rights to repurchase the ties from the market. The designated date after the call protection has ended that an issuer can call its bonds is referred to as the beginning call date.
Other Considerations
In anticipation of the future date when the old bonds will be repurchased, the proceeds from the new consequences are held in escrow and invested in low yield but high credit quality vehicles, such as cash investments or Treasury convictions that mature around the same time as the original bonds. On the first call date or subsequent call beaus, the funds held in escrow are used to settle interest and principal obligations to investors of the old bond. The interest accumulated from the Funds securities pays off the interest from the pre-refunded bond.
Like most municipal bonds, interest on pre-refunded constraints is exempt from federal income tax and some state taxes. This tax benefit makes pre-refunded bonds an inviting investment option for investors in the high-income tax brackets.
Example
For example, suppose that in June 2016, XYZ City unfaltering to call its 9% callable bond (originally set to mature in 2019) for $1,100 on its first call date of January 2017. In July, XYZ Burgh issued a new bond yielding 7% and took all the proceeds from that bond and invested them into T-bills, ensuring that adequacy money would be available to retire the issue come January.