Module 5 Part 3
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Refunding or Advanced Refunding
When bonds are issued in times of high interest rates, the issuers anticipate that the interest rates will come down in the future, at which time they can call the bonds in. For this reason, almost all municipal bonds have a CALL FEATURE.
The call feature is outlined in the indenture, as well as in the official statement, which is the municipal equivalent of the prospectus. These documents outline the method of calling in the bonds prior to the maturity date. The call price is at a premium in the early call years, decreasing to par after three to five years.
When the issuer calls the bond prior to maturity and issues a new bond, the issuance of the new bond to replace the old bond is called REFUNDING. Refunding occurs when a municipality issues a new bond for the sole purpose of using the proceeds to pay off the amount of an outstanding bond it wants to refund. To be able to do this, the outstanding bond must be callable. The issuer usually pays a premium for the privilege to call these bonds early. Any new issue that is used to refund the existing issue must be in an amount sufficient to cover the outstanding issue, plus any other costs. The calling of the bonds is known as an IN-WHOLE CALL.
REFUNDING and PRE-REFUNDING
Allow issuers to call in bonds on which they are paying high interest rates and reissue them with lower interest rates — an obvious benefit to issuers. This is also done to reduce the amount of the outstanding bonds completely. Sometimes, issuers refund a bond to change the maturity dates or the type of bond. For example, a municipality may call in a term bond and issue a serial bond. Refunding early can improve the credit rating for the issue. The rating of the refunded issue improves with both Standard and Poor’s and Moody’s rating services. Pre-refunding always improves the marketability of a bond.
ADVANCED REFUNDING or PRE-REFUNDING
If the issuance of the new bond occurs prior to the time when the municipality can call in the outstanding bond, the early issuance of the new bond to pay off the old bond is called ADVANCED REFUNDING or PRE-REFUNDING
Occurs when a municipality issues new bonds for the sole purpose of refunding outstanding bonds, when the outstanding bonds are not yet callable at the time the new bonds are issued. The proceeds from any new bond issued for refunding must be put into government securities, with maturities coinciding with the callable date of the existing bond. These securities must be kept in an escrow account. The interest that is generated from the government securities must be enough to cover the debt service of the new bonds.
Partial Called Bonds
Part of an outstanding bond can be called at some future date without being refunded if the issuer has generated sufficient money to do so. This could be from more taxes collected than were anticipated, or extra revenues generated from a facility. Once the first call date has arrived, the issuer can reduce the interest costs by calling in some of the longer maturity bonds, if it is a serial bond, or some of the term bonds that mature all at the same time.
Any time a bond is called, the market price goes to the call price and stays there, thus limiting the price of the bond.
When an issuer is able to pre-refund an outstanding bond with a lower interest, as stated above, the issuer invests the proceeds from the new issue into U.S. government bonds. Government bonds usually pay a higher interest than the municipal bonds, and thus the interest on the new municipal bond is paid for by the income generated from the government bond.
Often the issuer ends up not calling in the bond, but just keeps the existing bond paying the interest received from the government bond. In the meantime, the issuer lets the taxes or revenues pay for the new bond interest and principal payments. The old bond is now guaranteed by a U.S. government bond, and takes on an AAA rating. The interest is being paid by the interest received from the government bond, called "defeasing of the interest," and the issuer does not call the old bond in, but just pays the interest and principal when due. At some point, the issuer calls in the old bond and pays it off with the proceeds from the U.S. government bond. When the bond is called, it is known as a DEFEASED CALL and is called at a premium in the early call years, decreasing down to par after three to five years.
Sinking Fund Call
ALL term bonds and MANY serial bonds have SINKING FUNDS in which money is put away to pay for principal when it is due. Sinking funds are usually required of term bonds, but are optional on serial bonds. Any money in the sinking fund must be invested in U.S. government bonds.
After the first call date, if there is money in the sinking fund, many issuers call in a part of the outstanding bond that is callable, according to the call policy outlined in the indenture. This becomes a PARTIAL CALL and the bonds are called at a premium in the early call years, but it decreases to par after three to five years.
Extra-Ordinary Called Bonds
An EXTRA-ORDINARY CALLED bond is that part of a bond issue that was not needed to complete the project for which the bond was issued. As an example, a $60 million bond issue to build a stadium only uses $55 million dollars to complete the facility. Now the issuer must pay this extra $5 million dollars back to the bondholders since the money was not needed. The issuer may do this at any time after the project is completed, and does not have to wait for a call date. This is to the benefit of both the issuer and the bondholders, as it makes the debt service costs lower, and makes the rest of the issue stronger.
The calling of the extra-ordinary bonds is ALWAYS at par.
Catastrophe Called Bonds
A bond that is issued to build a municipal requirement, such as a bridge, a stadium, or other project, generates the income from that project. If a natural or other disaster occurs, and the project is no longer useable, the issuer receives insurance on the project, and then calls in the remaining parts of the bond issue. Income is no longer be generated from the project, insurance has been paid to the issuer, and now the issuer must pay the bondholders. An example of this is the bridge that collapsed in Minneapolis, Minnesota in 2007.
The calling of the catastrophe bonds is ALWAYS at par.
When a bond is called, investors are typically disadvantaged because they have to forego being paid a higher interest rate by the bond compared with current interest rates. For this reason, adding a CALL PROTECTION
to an issue may have the following restrictions:
- •The issuer may not be able to call the bonds for a period of time after issuance.
- •The bond can only be called at a premium, which at least partially covers the investors’ loss of interest.
A municipality has pre-refunded its $30 million outstanding bond. The old bonds will not be called for 3 1/2 years. What can the municipality do with the proceeds from the refunding issue?
(A) Put the money in the bank.
(B) Invest in other municipal bonds.
(C) Invest in derivative products to generate greater income.
(D) Invest in government bonds.
Answer (D) Invest in government bonds. This is all the municipality is allowed to do. The proceeds from any new bond issued for the purpose of refunding must be put into government securities, with maturities coinciding with the callable date of the existing bond. These securities must be kept in an escrow account. The interest that is generated from the government securities must be enough to cover the debt service of the new bonds.
THE PROCESS OF REDEEMING BONDS
When a bond matures or is called, the owners of the bond want to receive the principal. If a certificate has been issued, the certificate must be delivered to the issuer or their trustee for the principal to be returned.
For BEARER BONDS, whoever holds the bond can REDEEM it, either when it matures or when it is called.
For REGISTERED BONDS, the registered owner can redeem the bond by sending the bond certificate to the issuer or the receiving agent, who sends them a check for the principal amount of the bond that is presented and the accrued interest if owed.
For BOOK-ENTRY BONDS, the trustees send the principal amount and the last interest payment to the investor they have on their books. No certificate has to be presented to receive the money. If the bond is book-entry, the owner receives a check and does not have to worry about missed interest payments, as can happen in registered bonds, and as often occurs with bearer bonds.
For registered and bearer bonds, if bondholders fail to collect the principal or fail to see the redemption notice, they do not lose anything except an interest payment on the bond. For book-entry bonds, the bondholders can tell if the bond has been called, especially if they missed the redemption notice, since the principal and interest are sent automatically.
NOTICE OF REDEMPTION
If issuers wish to call a bond, they must give NOTICE OF REDEMPTION at least 30 days in advance and must publish the intent to call the bonds in a national financial publication (e.g., The Wall street Journal). The process for calling a bond is outlined in its indenture. Term bonds are called on a random selection basis. Serial bonds are called in inverse chronological order of maturity (oldest ones first). However, if only a portion of a year’s issue is called, the bonds in that year are called on a random basis.
Bonds are usually (but not always) callable at a premium. If the bond is callable at a premium, then the premium call price probably will decrease as the bond gets closer to maturity. The call price is at par within five years of maturity. If a bond has been called, it will be listed in the Bond Buyer, and broker/dealers have an obligation to tell their clients of the call.
A municipality has issued a serial bond. The city has just had an influx of money and would like to call the bonds. By what method would the city call the bonds? (A) Inverse chronological order (B) By random lot (C) Inverse numerical order (D) Inverse interest order FIRE Drill
Answer (A) Inverse chronological order. The city always takes serial bonds by the oldest ones first, which usually have the highest interest rate. If these were term bonds, the city would use a random method.
ANALYZING MUNICIPAL BONDS
When analyzing municipal bonds, there are many aspects to consider.
ANALYZING GENERAL OBLIGATION BONDS
For general obligation bonds, the PER CAPITA DEBT, the debt per person, is the important aspect to look at in analyzing the debt structure of the municipality. It is important to see if the municipality can afford the bond issue.
The issue of OVERLAPPING DEBT is an important aspect that should be considered in analyzing a general obligation municipal issue, but not a revenue municipal issue.
•OVERLAPPING DEBT is a general obligation bond indebtedness that is shared by two taxing entities and benefits both areas. Overlapping debt is a situation where two neighboring cities within a county both benefit from the bonds that have been issued by the county.
NET DIRECT DEBT
When there is no overlapping debt, the per capita debt is known as the NET DIRECT DEBT. In computing net direct debt or direct debt, use the following formula:
- OLD DEBT + NEWLY PROPOSED DEBT
- CITY POPULATION
Write this formula out three times
Remember, Net Direct Debt has three words in it, so it has two words on top of the equation.
When there is overlapping debt, the per capita debt is known as NET DEBT. In computing net debt, use the following formula:
NET DEBT =
- OLD DEBT + OVERLAPPING DEBT + NEWLY PROPOSED DEBT
- CITY POPULATION
- Net Debit has two words, so it has three words on the top of the formula
- Know these two formulas! - per the book
Co-Terminus Debt Service
When two or more municipal entities have the same boundaries, they are said to be co-terminus taxing entities. All their debt is overlapping.
Co-Terminus Debt Service Example:
Example: The City and County of San Francisco — city, county, school district, water district, and sewer district all have the same boundary.
ANALYZING REVENUE BONDS
The FIRST step in analyzing any revenue bond is to look at the FLOW OF FUNDS as outlined in the BOND INDENTURE, a copy of which is found in the official statement. This explains how the money will be spent and how solvent the issuer is.
The revenues pledge indicates how the interest on the bonds will be paid — an important point for bondholders.
The SECOND step is to look at the other COVENANTS in the indenture. The most important are:
Additionally, an analysis of revenue bonds should include any or all of the following:
- •Rate covenants
- •Insurance covenants, which provide for insurance on the project
- •Maintenance covenants
- •Feasibility studies and a competitive analysis
- •Engineering studies
- •Capital improvement programs
- •A determination of whether the issuer can raise rates freely without interference from the municipality or other government agency
- •A determination of whether the customer base is diversified and not, therefore, dependent on one major user
- •A comparison of rates in similar projects in the area or relatively close in proximity
- •Tax base and population, whether growing, diminishing, or staying even
FIRE Drill Which of the following is the method of finding the net debt of a municipality?
(A) Municipal debt ÷ City population
(B) (Municipal debt + overlapping debt) ÷ City population
(C) Municipal debt ÷ County population
(D) (Municipal debt + overlapping debt) ÷ County population
Answer (B) (Municipal debt + overlapping debt) ÷ City population. The question asked for net debt, which includes overlapping debt. If the question had asked for net direct debt, there would not be overlapping debt.
DEBT SERVICE is the amount of principal and interest that must be paid each year. If the bond is a term bond, the debt service is the same until the maturity date. At maturity, the bond has the same interest cost plus the principal that must be paid back at that point. If the bond is a serial bond, the debt service is composed of both principal and interest, and can change each year or remain the same.
•LEVEL DEBT SERVICE is when the total payment of principal and interest stays the same throughout the life of the bond. Remember, debt service is composed of principal plus interest.
DEBT SERVICE COVERAGE
For a REVENUE BOND, an analyst also considers the debt service coverage ratio based on a GROSS REVENUES PLEDGE or a NET REVENUES PLEDGE.
GROSS REVENUES PLEDGE
Write this equation out and memorize it
- TOTAL REVENUES
- DEBT SERVICE
NET REVENUES PLEDGE
Write this equation out and memorize it
- TOTAL REVENUES - MAINTENANCE
- DEBT SERVICE
NET REVENUES PLEDGE Example:
Example The City of San Rafael’s water revenue bond debt statement carries the following revenues and payments. Determine the debt service coverage under a net revenues pledge.
- Revenues $15 million
- Interest $2 million
- Principal payments $1 million
- Operating expenses $9 million
The debt service coverage ratio of this net revenues pledge facility is determined by subtracting the operating expenses from the revenues, or
$15 million minus $9 million, which equals $6 million. Then by dividing this $6 million by the debt service of $3 million (the principal and interest
), we arrive at a 2-to-1 debt service coverage ratio, which is a good ratio.
If the facility had a GROSS REVENUES PLEDGE, the total $15 million in gross revenues would have been available for the debt service. This results in a 5-to-1 ratio, which is a superb ratio.
Municipal bond issuers purchase INSURANCE for its bonds in case the municipality defaults on the interest and principal payments
. Insurance is mainly to protect the investor. Because it benefits the investor, the interest on the issue is usually lower.
- Municipal bond insurance organizations include:
- •MBIA — Municipal Bond Insurance Association
- •AMBAC — American Municipal Bond Assurance Company
- •FGIC — Federal Guarantee Insurance Corporation
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