PRE-REFUNDED
MUNICIPAL BONDS
Pre-refunded municipal bonds offer high quality and higher income
One of the most attractive yet overlooked areas in the municipal bond market is the pre-refunded bond. Bonds are often
advance refunded when interest rates drop to the point where issuers can refinance their outstanding bond debt at a substantially
lower rate of interest. Pre-refunded bonds are considered the safest of all municipal bonds. In addition, they offer higher
current income and higher taxable equivalent yields compared to other bonds of top credit quality and similar maturity.
Pre-refunded municipal bonds provide an attractive investment alternative for investors who:
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typically purchase only Treasury securities;
seek to maximize their current income;
seek the highest quality investments;
wish to enhance the after-tax yield of their portfolio;
prefer short-term bonds.
HOW ADVANCE REFUNDING WORKS
In periods of declining interest rates, municipalities
often issue new bonds at lower interest rates to refinance
outstanding debt much like a homeowner can refinance
a mortgage. Because bonds are callable only on certain
predetermined dates (generally ten years after issuance),
the old bonds, which have been “pre-refunded” with the
new issue, remain outstanding until the earliest call date.
This optional call date then becomes the bond’s redemption
date. The proceeds from the new refunding bond issue
are invested in government and/or cash securities and held
in escrow. Principal payments and interest earned on the
escrowed securities are sufficient to cover interest and
redemption amounts on the refunded bonds when due
through the call date.
For example, assume that ABC City issued $10 million par
amount of 8 percent coupon debt in 2000 that is originally
due in 2020. Today, when interest rates are lower, ABC
City issues new bonds with a coupon rate of 5 percent,
in an amount sufficient to refund the 2000 bonds.
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Because the 2000 bonds are not callable until 2010, the
issuer places the proceeds of the 2005 issue in an escrow
account. Using the proceeds, a portfolio of government
obligations and/or cash is contructed with maturities that
match the principal and interest payments on the 2000
bonds through the 2010 call date plus the principal and
any call premium due on the bonds that mature after the
2010 call date.
The issuer has now lowered the interest rate on its
coupon payments from 8 percent to 5 percent.
The older bonds are now escrowed to their call date
in government and/or cash securities.
Pre-refunded bonds usually trade at a premium, meaning
they’re priced above par (100). They carry higher coupon
rates relative to prevailing interest rates, which is why they
were refunded. The issuer was able to issue new bonds at
lower interest rates, thereby reducing its borrowing costs.
However, the old bonds technically remain outstanding
until the redemption (call) date. The prices of the highercoupon pre-refunded bonds trade at a premium to par as
a function of current lower interest rates. Compared to
similar bonds priced at par, premium bonds can offer
investors the advantages of higher current income and
higher current yield.
VALUE OF PRE-REFUNDED MUNICIPAL BONDS
TO INVESTORS
High credit quality
With pre-refunded municipal bonds, an investor receives
the lowest risk and highest quality investment—tax-exempt.
Credit quality on pre-refunded municipal bonds is very high
because the interest and principal payments come from
Treasury securities. These bonds typically receive a AAA
rating if the rating is reviewed after refunding occurs.
Higher current income
Current income will be greater from premium bonds than
par bonds, because the higher the coupon rate the higher
an investor’s semiannual income payments. For example,
a premium bond with an 8 percent coupon pays annual
interest of $80, while the par bond with a 5 percent coupon
pays interest of $50 over the same period. (Investors should
recognize that these higher coupon payments represent a
partial repayment of principal.) For investors who wish to
maximize their current income without extending maturities
or lowering credit quality, pre-refunded bonds provide an
attractive investment.
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Pre-refunded municipal bonds offer high quality and higher income
Known Redemption
Because the bonds are pre-refunded to a specific call date,
there is no uncertainty as to the length of time the investment
will remain outstanding. The income stream from the coupon
payments is locked in until the specified redemption date.
This is an attractive feature for those investors who require
noncallable bonds.
Higher Yield
Premium bonds are overlooked by many investors who do
not understand their features. As a result yields for AAArated pre-refunded bonds may offer higher yields than
other par-priced AAA-rated municipal bonds. The table
to the right shows recent yields available on pre-refunded
municipal bonds compared to other AAA-rated municipal
bonds and to Treasury securities after federal taxes. (The
effects of state taxes have not been considered here.) For
example, a five-year pre-refunded municipal bond priced
to yield 3.12 percent produces a taxable equivalent yield of
4.80 percent (assuming a federal tax bracket of 35%). This
represents a pickup in yield for the investor of approximately
106 basis points over the Treasury note, which is priced to
yield 3.74 percent.
Tax Treatment of Premiums
The premium paid on a municipal bond is returned to
the investor in the form of increased tax-exempt income
over the life of the bond. For this reason, the federal tax
code does not allow investors to take a capital loss when a
tax-exempt bond purchased at a premium is redeemed.
Instead, it requires that premiums be amortized to maturity
or to a pre-refunded call date. Investors should consult
with their tax advisors for a specific interpretation of tax
treatment.
*Thomson Financial Securites Data, 2004.
Piper Jaffray does not provide legal or tax advice.
Since 1895. Member SIPC and NYSE.
©2005 Piper Jaffray & Co. 6/05 PC-04-2378 piperjaffray.com
For shorter-term investors, pre-refunded municipal bonds
offer a unique set of characteristics: safety, higher current
income and higher after-tax yields. As a leading underwriter
of municipal bonds*, we maintain a broad selection of prerefunded bonds. For more information, please call your
Piper Jaffray financial professional.
YIELD COMPARISON
(as of 5/27/2005)
Maturity AAA Muni
Pre-Re
Muni
Pre-Re Tax
Equiv. Yield
Treasury (35% Federal
Security
Rate)
2
2.77%
2.85%
3.53%
4.38%
5
3.08%
3.12%
3.74%
4.80%
10
3.65%
3.74%
4.05%
5.75%
15
4.00%
4.28%
4.38%
6.58%
20
4.29%
4.61%
4.49%
7.09%
30
4.58%
4.81%
4.42%
7.40%
Source: Piper Jaffray, Bloomberg