11/20/2017

Pre-Refunded Bonds: A Quick Lesson

by

All seven of Aquila Group of Funds’ Single-State Municipal Bond Funds, which focus on high credit quality and providing a high level of double tax-exempt income, hold Pre-Refunded Municipal Bonds. These bond issues – when backed by US Treasury Securities – are considered to be the highest-quality, and often provide higher current income than new municipal bond issues during periods of declining interest rates.

What is a pre-refunded municipal bond?

Just like home owners, in declining interest rate environments, municipalities often take the opportunity to refinance their outstanding debt – but it’s not as simple as taking out an additional loan to pay off what is due. Bond issuers are obligated to pay interest to bond holders for a specific amount of time – to maturity or a call date. Interest rates may drop to an attractive level years before the call date or maturity – and this may present the opportunity for a bond issue to become pre-refunded.

Here is how it works:

  • Bond X is issued in 2010 to fund new roads at a 5.5% interest rate with a 30-year maturity in which the issuer is permitted to pre-pay or “call” in 2020.
  • Interest rates drop in 2014 to 3.0% – 6 years prior to the first call date for Bond X.
  • The issuer of Bond X issues Bond Y in 2014 at a 3% interest rate.
  • The proceeds from the sale of Bond Y are invested in a combination of securities and cash, in this case US Treasury securities, which are held in an escrow account administered by a trustee with a 2020 maturity corresponding to the call date of Bond X.
  • Now Bond X is backed by Moody’s/Fitch Aaa/AAA rated US Treasury securities and is a pre-refunded bond issue.
  • In some cases pre-refunded bonds are defeased, which means that the bonds have gone from being an obligation of the issuer to an obligation supported by securities held in the escrow fund, or in this case by US Treasury securities. After defeasance, the bonds are no longer considered an obligation of the issuer.

What are the benefits of pre-refunded bonds?

Two attractive aspects of pre-refunded bonds are their high quality and coupon payment. Most pre-refunded issues that are backed by US Treasury Securities carry the Moody’s and Fitch Aaa/AAA rating, while also maintaining the coupon payment from the original issuance. In our example above, Bond X, if backed by US Treasury securities, would have the AAA credit rating and a 5.5% coupon, compared to new municipal bonds being issued with 3.0% coupons.

Many municipal bond mutual funds hold pre-refunded issues not only for their credit quality and coupon, but for their duration and liquidity. They are typically the most liquid segment of the municipal bond market. Considering that pre-refunded issues are escrowed to their call date, they have short to intermediate maturities and may have less price fluctuation than bonds with longer maturities. While past performance does not guarantee future results, pre-refunded bonds have been known to retain value relative to the Treasury, stock and bond markets during periods of volatility.

Municipal bond issuers benefit from pre-refunding by reducing their long-term borrowing costs, and if the bonds are defeased, those bonds are no longer recorded on the issuer’s balance sheet. Defeasance transfers the debt obligation from the issuer to the escrow fund, which, in our example, holds securities guaranteed by the US government and used to make remaining payments on the original municipal issue. However, not all pre-refunded bonds are defeased.

Is there a downside?

Pre-refunded bonds are still susceptible to interest rate risk, and if they are purchased at a premium and sold before maturity, investors may incur a loss. Since these issues have been escrowed to their call date, they may not be suitable for long-term investors.

Consideration should be given to the risks of investing. Investments in bonds involve certain risks including a decline in value due to rising interest rates, a real or perceived decline in credit quality of the issuer, borrower, counterparty, or collateral, adverse tax or legislative changes, court decisions, market or economic conditions. Fund performance could be more volatile than that of funds with greater geographic diversification. For certain investors, some dividends may be subject to Federal and state taxes, including Alternative Minimum Tax (AMT). Please consult your professional tax advisor.

Before investing in one of the Aquila Group of Funds, carefully read about and consider the investment objectives, risks, charges, expenses, and other information found in the Fund prospectus. The prospectus is available here, from your financial advisor, or by calling 800-437-1020.