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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.

Suggested Citation

  • Andrew Ang & Richard C. Green & Yuhang Xing, 2013. "Advance Refundings of Municipal Bonds," NBER Working Papers 19459, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19459
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    References listed on IDEAS

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    1. Glaeser, Edward L. & Ponzetto, Giacomo A.M., 2014. "Shrouded costs of government: The political economy of state and local public pensions," Journal of Public Economics, Elsevier, vol. 116(C), pages 89-105.
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    4. 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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    Cited by:

    1. Whitaker, Stephan & Ergungor, O. Emre, 2016. "Premium Municipal Bonds and Issuer Fiscal Distress," Working Paper 1534, Federal Reserve Bank of Cleveland.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies

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