Advance Refundings of Municipal Bonds

Municipal bonds are often “advance refunded.” Bonds that are not yet callable are defeased by creating a trust that pays the interest up to the call date, and pays the call price. New debt, generally at lower interest rates, is issued to fund the trust. Advance refunding has zero net present value in the case of no uncertainty and no fees, otherwise the transaction destroys value. We estimate that for the typical bond in an advance refunding, a municipality loses approximately 1% of the par value not including fees, which translates to an aggregate value lost of over $4 billion from 1996 to 2009 for the bonds in our sample, which are roughly half of the universe of advance refunded bonds that traded during the period. The worst 5% of bonds lose represent a destruction of $2.9 billion for taxpayers. Municipalities may engage in advance refunding because it enables them to borrow to fund current operating activities in exchange for higher interest payments after the call date. We find that municipalities in the most corrupt states destroy the most value by advance refunding.