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Advance Refundings of Municipal Bonds

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  • Andrew Ang
  • Richard C. Green
  • Yuhang Xing

Abstract

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. Issuing new securities generally has zero net present value. In this case, however, value is destroyed for the issuer through the pre-commitment to call. We estimate that for the typical bond in an advance refunding, the option value lost to the municipality is approximately 1% of the par value not including fees. This 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 the transactions represent a destruction of $2.9 billion for taxpayers. We discuss various motives for the transaction, and argue that a major one is the need for short-term budget relief. Advance refunding enables the issuer to borrow for current operating activities in exchange for higher interest payments after the call date. We find that municipalities in states with poor governance generally destroy the most value by advance refunding.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19459.

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Date of creation: Sep 2013
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Handle: RePEc:nbr:nberwo:19459

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  1. Edward L. Glaeser & Giacomo A. M. Ponzetto, 2012. "Shrouded Costs of Government: The Political Economy of State and Local Public Pensions," NBER Chapters, in: Retirement Benefits for State and Local Employees: Designing Pension Plans for the Twenty-First Century National Bureau of Economic Research, Inc.
  2. Andrew J. Kalotay & Deane Yang & Frank J. Fabozzi, 2007. "Refunding efficiency: a generalized approach," Applied Financial Economics Letters, Taylor and Francis Journals, vol. 3(3), pages 141-146.
  3. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-92.
  4. Vijayakumar, Jayaraman, 1995. "An empirical analysis of the factors influencing call decisions of local government bonds," Journal of Accounting and Public Policy, Elsevier, vol. 14(3), pages 203-231.
  5. Jamshidian, Farshid, 1989. " An Exact Bond Option Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 205-09, March.
  6. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
  7. Robert Novy-Marx & Joshua D. Rauh, 2009. "The Liabilities and Risks of State-Sponsored Pension Plans," Journal of Economic Perspectives, American Economic Association, vol. 23(4), pages 191-210, Fall.
  8. Kraus, Alan, 1973. "The Bond Refunding Decision in an Efficient Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 8(05), pages 793-806, December.
  9. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  10. Tima T. Moldogaziev & Martin J. Luby, 2012. "State and Local Government Bond Refinancing and the Factors Associated with the Refunding Decision," Public Finance Review, , vol. 40(5), pages 614-642, September.
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