New Research: Advance Refunding Always Destroys Value - Use a Swap

Posted by Peter Orr on Aug 08, 2013

“Real knowledge is to know the extent of one’s ignorance” - Confucius

According to Bloomberg, there are just over $1.5 trillion fixed-rate, callable, unrefunded, fixed rate municipal bonds outstanding today. Helping issuers analyze, evaluate and ultimately execute current and advance refundings on these types of bonds is an integral part of public finance. Brand spanking new research  by Andrew Ang (Columbia), Richard Green (Carnegie Mellon), and Yuhang Xing (Rice) finds that in the presence of transaction costs, advance refundings always destroy value to the issuer. They state,

Advance refunding provides short-term budget relief, but it destroys value for the issuer. By pre-committing to call, the issuer surrenders the option not to call should interest rates rise before the call date. The value lost to the issuer, and transferred to bondholders, is the value of a put option on the bonds. In addition, since the assets in the [escrow] trust are Treasury securities, the transaction provides free credit enhancement for the bondholders, also at the expense of the issuer. Finally, the intermediaries who create the trust and issue the new bonds collect fees to do so.”  

They next empirically attempt to estimate the value lost from advance refundings using MSRB data from January 1995 to December 2009 capturing ~149,000 pre-refunded securities with aggregate par of $454.4 billion.Refunding question Interestingly they find the loss is rather small in both dollar and percentage terms. Hey issuers - nice timing!

One interesting question central to this topic is whether the ability to execute an advance refunding itself actually has value for the issuer. This research posits that the payoff from advance refunding is always zero at best i.e. there is no positive value assigned to the ability to advance refund. In fact, they argue that an interest rate swap is a better tool for the job,

“Even if the goal is to accelerate or borrow against the uncertain future interest savings associated with the call provision, a swap contract could achieve this more efficiently.”

But the question stands, some commercial analytics calculate an “Advance Refunding Option” which explicitly quantifies the ability to advance refund as an issuer benefit. This research clearly takes a contrary view. Who’s right and why?