What is the advance refund?
Early repayment refers to the withholding of proceeds from a new bond issue for more than 90 days before using it to pay (repay) the outstanding obligations of a bond issue. The Tax Cuts and Jobs Act (TCJA) repealed the gross income exclusion of interest on bonds issued to prepay another bond.
Early repayment should not be confused with early repayment, which involves the issuance of an enforceable bond.
- A bond is classified as an early redemption if it is issued more than 90 days prior to the redemption of the oldest bonds to be withdrawn with the funds from the new issue.
- Early repayment is most often used by governments looking to postpone paying their debts, rather than having to pay off a large amount of debt when it is due.
- Municipalities often use early repayments to lower borrowing costs and take advantage of lower interest rates.
Understanding early repayment
In corporate finance and capital markets, repayment is the process in which a fixed income issuer withdraws some of its outstanding callable bonds and replaces them with new bonds, usually on terms more favorable to the issuer in order to reduce financing costs. The new bonds are used to create a sinking fund to pay for the original bond issues, known as redeemed bonds.
Early repayment refers to the practice of taking the funds received from a new bond issue to pay off the debt of a previous issue. This can only happen after 90 days have passed. The issuance of the new bond is generally at a lower interest rate than the previous unpaid obligation. Municipalities often use early repayments to lower borrowing costs and take advantage of lower interest rates.
Early repayment can also refer to a bond issue in which new bonds are sold at a lower rate than pending ones. The bond issuer places the proceeds of the sale of the newer issue (redemption bond) in an escrow account until you call the oldest issue (redeemed bond).
Early repayment is most often used by governments looking to postpone paying their debts, rather than having to pay off a large amount of debt today. In some ways, this is comparable to a homeowner’s mortgage refinance. In 2017, early repayment bonds totaled $ 91 billion and comprised 22.2 percent of the total $ 3.8 trillion municipal bond market.
Regulation of early repayment
Regulators have shown some concern about possible abuses of early repayments. Since municipal bonds tend to have lower rates, municipalities could use advance repayment to issue unlimited amounts of debt at a low rate. The city could then invest in higher-rated investments. For this reason, regulators have imposed rules limiting the tax-exempt status of interest on the repayment of bonds. Additionally, due to a provision in the Tax Cuts and Jobs Act of 2017, interest income is not tax-exempt for early repayment bonds issued after December 31, 2017.
Individual states have laws that impose limits on early repayments, such as statutory maturities and limits on interest rates. The IRS restricts investment performance gains from an early repayment bond issue. Additionally, arbitration regulations generally allow municipalities to advance redemption bonds only once during the life of the bond. Before initiating early repayment, cities must first ensure that the amount of money to be saved through the transaction is worth any issuance costs.
Early repayment example
Early repayment is popular in low interest rate environments, when bond issuers may seek to take advantage of lower rates by refinancing outstanding bonds that have not yet matured. For example, suppose a municipality wants to roll over its current unpaid bonds at a new, lower rate. The city would take the proceeds from the sale of the redeemable bonds and invest them in United States Treasury bonds or other taxable government securities. The Treasury bonds are then deposited into a collateral portfolio. The principal and interest earned on the Treasury bonds in the collateral portfolio are used to settle the old bonds.