A recent study of the economics of advance refundings asserts the provocative conclusion that "advance refunding has zero net present value in the case of no uncertainty and no fees, otherwise the transaction destroys value." The study dated August 3, 2013 by Andrew Ang (Columbia University), Richard C. Green (Carnegie Mellon University) and Yuhang Xing (Rice University) which has received some attention in the financial press, is based on a sample of approximately 150,000 advance refundings undertaken between 1995 and 2009.

Though a close reading of the study suggests that "destroys value" is an overly dramatic phrasing of the proposition that advance refundings may not maximize the value of a call option (and therefore of a refunding opportunity), the study's attention-grabbing assessment of the efficacy of advance refundings raises a more subtle set of issues that bear careful consideration in evaluating the pros and cons of particular advance refundings.

The study focuses attention on the value of the call option on bonds that is surrendered at the time of an advance refunding. According to the authors: "By pre-committing to call, the issuer surrenders the option not to call should interest rates rise before the call date. The value lost to the issuer, and transferred to bondholders, is the value of a put option on the bonds. In addition, since the assets in the trust are Treasury securities, the transaction provides free credit enhancement for the bondholders, also at the expense of the issuer. Finally, the intermediaries who create the trust and issue the new bonds collect fees to do so."

The study includes a bounty of differential equations to back its conclusions. It dedicates a portion of its text to the unremarkable proposition that an advance refunding is uneconomical if interest rates are the same on the date of the advance refunding as they would be on the date of a current refunding. Such a static interest rate world may lay the groundwork for the mathematical analysis but is not the world in which issuers function.

The study's headline conclusion that, in a world of fluctuating interest rates, an advance refunding "destroys value" requires some unpacking. For a non-mathematician, the study's focus on the value of "the option not to call should interest rates rise before the call date" is not intuitive, and it is unclear whether that option differs from the more readily understood option to call should interest rates fall further before the call date, which is (also) surrendered when a high-to-low advance refunding is implemented. (Some advance refundings, of course, are driven by factors other than interest rate savings, such as the need or desire to eliminate troublesome covenants, and therefore their timing and "success" should not be evaluated solely on the economics.)

In refundings, as in most other matters, timing is everything. Any fixed rate or hedged refunding involves an opportunity cost, in that it precludes, or may preclude, alternative future refundings at what may turn out to be a more optimal time. This is true of current refundings as well as of advance refundings, as current refundings typically create a new no-call period for the refunding bonds (or, in the case of a synthetic fixed rate, a potentially punitive swap termination penalty) and therefore restrict the issuer from implementing a more advantageous current refunding during the new no-call or swap period. However, the study focuses not to on the timing "option" surrendered when any refunding is implemented, but on what it characterizes as inevitable value destruction in the specific context of advance refundings.

The study acknowledges that the direction of interest rates over time impacts the financial merits of a particular advance refunding, and allows (perhaps) that the desire to lock in a refinancing rate is a justifiable goal, but casts doubt on the efficiency of advance refundings in achieving that goal.

"When there is uncertainty about future rates," the study notes, "the interest savings that will eventually be realized by waiting to call are uncertain, and thus so are the differences through time associated with an advanced versus a (delayed) current refunding. Indeed, surely part of the appeal of pre-refunding is confusion about the need to engage in the practice to 'lock in' interest savings that would otherwise be lost should rates rise before the call date. If the goal is to hedge this uncertainty, then a variety of hedging strategies could achieve this without precommitting to call. Even if the goal is to accelerate or borrow against the uncertain future interest savings associated with the call provision, a swap contract could achieve this more efficiently."

The above language appears to shift the study's conclusion from one that posits that advance refundings are inherently value-destructive to one that posits that advance refundings are less efficient than virtual refundings effected through swaps. Irrespective of whether there is any back-up for the latter proposition, virtual refundings introduce counterparty risk not present in advance refundings, may involve different political considerations given the use of derivatives, and may result in different financial statement treatment, and therefore cannot be compared on an apples-to-apples basis.

Some of the study's assertions about the impact of interest rate changes are perplexing, or at least underexplained. In positing that advance refundings have disadvantages even in a rising interest rate environment, the study asserts that "the precommitment to call must be destructive of value, because it forces the issuer to call even when it is suboptimal to do so." This 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.

The "destructive of value" concept, and the related high level math, may establish no more, and no less, than that due to the escrow costs and the increased principal amount of the refunding debt, a high-to-low advance refunding is inefficient relative to a refunding in a similar rate environment conducted closer to the call date. But in real life the perfect may be the enemy of the good, and it may turn out counterproductive, and destructive of actual value, to turn down a reasonably effective advance refunding in order to wait for a better current refunding that may be statistically probable but never materialize.

The study acknowledges that prior studies of advance refundings have advocated calculating "refunding e?ciency," the ratio of the present value of interest savings over the life of the newly issued debt to the lost option value, and concluded that a relatively high ratio (e.g., 90%) justifies an advance refunding.  Some prominent issuers do, in fact, require that loss in option value be factored into refunding proposals, not just the amount of present value savings. Others adhere to the old maxim that present value savings in the hand are worth two in the bush.

The authors seem to strain for a splashier, less nuanced conclusion to distinguish their work from prior studies. Though their study intimates that advance refundings are inherently money-losers, it concedes that its large sample of transactions shows that "[m] ost of the value lost is due to a small fraction of the transactions." The study's admonitions against advance refundings are loud, but unclear, and its implicit premise that there is no such thing as a well-timed or financially sensible advance refunding is left unproven by the welter of equations.

As numbers have meaning, so do words. The study is not just a benign academic exercise regarding the efficiency of advance refundings; the authors' wrap-up states that "[g] iven the economic losses imposed on taxpayers by advance refunding, Federal authorities should carefully consider the tax-exempt status of any advance refunding." The fact that the authors can point to a few examples of highly inefficient advance refundings in a study indicating that most advance refundings fall only slightly short of full mathematical or economic efficiency seems a thin basis for weighing in against advance refundings in the ongoing tax policy debate, yet the authors offer up their study as ammunition for the anti-advance refunding camp.

As this study points out, "[a] dvance refundings have received very limited attention in the academic literature." These academics have devoted themselves to an opaque, important and for some issuers underanalyzed topic in municipal finance, and raised issues worthy of focus, whether or not one agrees with the conclusions. Though this study may not be a leading indicator of a spate of future advance refunding Ph.D. theses, it may well compel a counter-study from the many proponents of advance refundings.

Leonard Weiser-Varon is a bond lawyer and a member of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.