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A significant impact on the municipal bond market from the recently enacted tax overhaul package has been the elimination of tax-exempt advance refundings for issuers of muni bonds. The prohibition against advance refundings has taken away a tool to reduce interest costs for issuers, who are now looking for options to increase their fiscal flexibility. Muni refundings have fallen by over 74% in the two months since the advance refunding prohibition.
Until January 1, issuers were able to take advantage of lower interest rates even though they may have had to wait a number of years until the original bonds could be redeemed. Proceeds from the advance refunding bonds would be deposited into an escrow account, and interest from the invested securities would pay the debt service on the original bonds until the bonds were callable. In contrast, the proceeds from current refunding bonds, which may still be issued on a tax-exempt basis, would be used to redeem the original bonds within 90 days of the issuance of the refunding bonds.
Two prime alternatives to advance refundings are issuing bonds with shorter call dates and issuing variable rate demand obligations (VRDOs) instead of fixed rate bonds. Typically, fixed rate muni bonds are issued with 10-year calls, which stipulate that bonds cannot be refunded in advance of their maturities for the first 10 years of their life. Under the old rules, investors would have call protection for 10 years, but issuers could still take advantage of lower rates by issuing advance refunding bonds. Now, without the advance refunding tool, some issuers are looking to increase their flexibility by reducing the call period from 10 to 5 years.
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The state of Wisconsin dipped its toe into the market last week by issuing bonds with 5-year calls. While it appears that Wisconsin has not had to pay a yield premium to gain more refunding flexibility, a bigger test for bonds with shorter calls will happen this week when the State of California is scheduled to issue about $2.1 billion of GO bonds. We expect that the state will market some bonds with 5-year calls.
Representatives of the California State Treasurer’s Office have indicated that they are also reviewing opportunities to issue VRDOs, which currently make up less than 6% of the state’s outstanding GO debt. VRDOs provide issuers with opportunities to take advantage of lower short-term rates and the flexibility to lock into fixed rates at a later date without triggering an advance refunding. There may also be more investor acceptance for VRDOs, as rates are at a high enough level to be attractive, while fixed rate bonds with short calls may face resistance from institutional investors.
Sources: Bloomberg News, California State Treasurer