ABSTRACT
In this entry, we discuss the mechanics of refunding in the municipal bond market. Refunding is similar to refinancing of a home owner's mortgage, by issuing a new bond to retire an old bond. We first discuss the concept of call option that allows the government to redeem an old bond prior to its maturity. Then we discuss the difference between current refunding and advance refunding. While current refunding is straightforward, advance refunding is more complicated, and it is the focus of this entry. Advance refunding requires the establishment of an escrow account to pay for debt service on the old bond until it can be redeemed at the earliest redemption date. The proceeds in the escrow account are invested in risk-free fixed-income securities that are also yield-restricted. This stringent requirement results in the federal government issuing a special Treasury security called the state and local government series to satisfy the specific investment need in an advance refunding. The entry also discusses the reason why the federal government allows state and local government only one advance refunding opportunity for a previously issued bond. While interest cost saving is the main reason for advance refunding, the entry also discusses several other important reasons why refunding occurs in the municipal bond market. The entry ends with an example in calculating the interest cost savings from an advance refunding transaction.
