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Commentary: Valuing Advance Refundings

AUG 12, 2013 10:57am ET

A recent study of the economics of advance refundings asserts the provocative conclusion that "[t]he widespread practice of advance refundings of municipal bonds is, at best, zero net present value, though wasteful of fees." This study may well compel a counter-study from the many proponents of advance refundings.

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Comments (6)
I appreciate and agree with much of the above analysis though I think there is at minimum one misunderstanding of the paper. In looking at what Ang et al consider a loss, they maintain that pre-committing to purchasing bonds at par (or par plus premium) on a call date many months or years ahead of the actual call eliminates the issuer's ability to NOT call the bonds at par should rates RISE sufficiently that it would not make economic sense to do so. For example, should rates have risen such that the underlying bonds were only worth 90 on the call date, the issuer being forced to redeem the bonds at par (plus perhaps a premium) via the escrow would be a minimum 10 point loss per bond, in a financial economic sense. This fact (with which I agree) stands in contrast to the above, "[the authors'] statement seems to bypass the key point that, once an advance refunding is implemented, the fact that the bonds are subsequently redeemed in a higher rate environment has no adverse impact, and is therefore neither "destructive of value" nor "suboptimal", and indeed would appear to confirm the wisdom of having locked in the refunding rate at a time when rates were lower." This is not true. Redeeming bonds at par plus any premium in a market where they could be worth well less than that is, in fact, suboptimal. Whether that commitment was made yesterday or 10 years ago is irrelevant.

As an aside, contrast the above example with a swap the authors mention. In this situation the issuer could unwind the swap at a gain, and maintain the call provision in their original and unrefunded bonds. I'm fully aware that that type of transaction involves entirely different risks and considerations but we must remember, the authors dwell in the luxuries of an ivy tower where counterparty exposures, swap authorizations, and political risk can be comfortably assumed away.

Thanks for the analysis and until the optimal stopping problem of advance refundings is solved, this will remain a topic of some debate.

Peter Orr, CFA
www.intuitive-analytics.com
Posted by petero | Monday, August 12 2013 at 1:27PM ET
I haven't read the report but presumably there would be a debt savings on the refunded bonds so that needs to be taken into consideration as to whether the trade is suboptimal or not.
Posted by Robert G | Monday, August 12 2013 at 3:38PM ET
On Peter's point, the bonds might only be worth 90 in that situation, but they still could only be redeemed at par. The issuer would have to do a tender offer to buy in the bonds at 90, which might or might not succeed and would involve increased expense and uncertainty. And to finance the repurchase it would need to issue bonds in a higher rate environment than was available when the advance refunding could have been done. Unclear that issuing fewer bonds at a higher rate on the call date is an improvement over issuing more bonds at a lower rate before the call date, when one factors in (i) the tender offer expense, (ii) that the issuer does not control the bondholders' decision to tender and (iii) that the higher interest period to maturity may be much longer than the advance refunding escrow period.

Len Weiser-Varon
Posted by lweiservaron | Monday, August 12 2013 at 5:04PM ET
Thanks Mr. Weiser-Varon for the response. Agree a tender offer is messy and not nearly the same animal as an (advance) refunding. I'm merely trying to explain Ang et al's economic perspective on this point. They are calling the issuer's obligation to redeem the bonds at par on the call date when those bonds would only be worth 90 in the open market otherwise, a "loss". A tender does not enter the equation; buying something at 100 when it's only worth 90 is the loss to which they refer and this is what leads to their "suboptimal" characterization. I frankly think it's difficult to not concede this point though I certainly don't agree with a number of their broad brush conclusions, many of which you rightfully call out.

Their point is (and don't kill the messenger) that people behave as if the only way to "lock in" low rates is via the mechanism of the advance refunding. But this same mechanism provides bondholders a windfall credit upgrade on the bonds to the call plus eliminates the ability of the issuer to NOT call the bonds should rates rise. The latter was the basis of their empirical study which I believe was conceptually sound, though I take issue with a number of the modeling details.

There also exists an economic value to the issuer in the form of cash flow and budgetary certainty that derives from an advance refunding structure. Does this admittedly hard-to-quantify but very real benefit offset the loss associated with turning an option into a firm forward commitment in the form of a funded escrow? This is one of a number of spots where I think they falter.

Peter Orr, CFA www.intuitive-analytics.com
Posted by petero | Monday, August 12 2013 at 11:31PM ET
Thanks, Mr. Orr. I appreciate your clarification of the "loss" of redeeming a bond at par when rates are higher than the coupon on the redeemed bond, and the redeemed bond is therefore trading at below par. But the fact is that issuers do not current refund (for savings purposes) when the rate for the refunding bonds is higher than the rate for refunding bonds. So the comparison in that instance is between an advance refunding that achieved some present value savings (because the refunding bonds are priced at a different time than the call), versus not doing a refunding and therefore not having any present value savings. While there is a theoretical "loss" inherent in the redemption at par if one ignores the difference in pricing environments, the actual loss if one compares doing the advance refunding versus not doing it is experienced by the issuer that passes up the advance refunding in the lower rate environment. You suggest, as does the study, that there are better ways of "locking in" low rates, presumably by using swaps. As noted, there are sound reasons why virtual refundings, even if factually more rewarding on the numbers, are not more popular than advance refundings. But in any event, if the study authors' intent was to establish that advance refundings destroy value relative to virtual refundings, it would seem the study should have included comparisons to virtual refundings done or available at the time of the advance refundings, rather than a single sentence with a general assertion that there are better ways of locking in savings.
Posted by lweiservaron | Tuesday, August 13 2013 at 8:42AM ET
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