How Does Advance Refunding Work?

Advance refunding can quickly turn into a jumble of complex money transfers and new interest rates. However, the reasoning behind this refinancing method is quite simple. Per definition, the entity in question usually has an old bond that they want to refinance so they can pay it off faster. The simplest way to refinance a bond is by issuing a new bond that brings in money quickly. Typically, this new bond has a lower interest rate than the original one that the company still needs to pay off.

At this point, the entity has the money to pay back the original bond—but there's a catch. There's one legal regulation for companies, corporations, and governments that want to refinance their bonds using advance refunding must follow. They must allow 90 days to pass before using the new bond to repay the original bond. So, it is common practice for the company, corporation, or government entity to work with outside finance specialists. These utside specialists are called underwriters. Underwriters manage this money until the company can fulfill the 90-day requirement.

Often, the company, corporation, or government entities, with the help of the underwriters, will buy U.S. Treasury bonds—bonds issued by the U.S. Treasury—with the money from the new bonds. These Treasury bonds make a profit over time from interest. But, advance refunding rules dictate that a company or government entity that purchases Treasury bonds this way cannot profit off these Treasury bonds. This law was made to prevent companies from abusing advance refunding.

Advance Refunding Example

Imagine you manage bonds in a city. A few years ago, the city you work with was issued a bond from an outside municipal bond firm. A municipal bond firm provides bonds to state governments (or governments in the state, such as city governments) and the federal government. In this case, you'll be using the bonds to fund the construction of a new apartment complex. Now, the interest rates for bonds have significantly decreased, and you are looking to refinance the interest rate for this bond.

The city is issued another new bond that would cover the costs and interest accumulated on the old bond. The interest rate on this new bond is lower and more affordable for the city in the long run. However, 90 days now have to pass before the original bond, and its interest can be paid back using the money from the new bond. You and the city decide that you will, in the meantime, use the money from the new bond to purchase Treasury bonds. Working with underwriters, you purchase Treasury bonds.

Once the required 90 days are up, you sell the Treasury bonds (before their maturity) and pay back the original bond. You decide to use the profit from the Treasury bond to pay the underwriter that you worked with.