Advance Refunding Explained: 2025 Guide on Costs, Benefits, and Regulations

Adam Hayes, Ph.D., CFA, is an experienced financial analyst and writer with over 15 years on Wall Street specializing in derivatives trading. Holding a master's in economics from The New School and a Ph.D. in sociology from the University of Wisconsin-Madison, Adam combines expertise in economics and behavioral finance. He is a CFA charterholder and holds FINRA Series 7, 55 & 63 licenses. Currently, he researches and teaches economic sociology and finance at Hebrew University in Jerusalem.

What Is Advance Refunding?

Advance refunding refers to the strategy of holding the proceeds from a newly issued bond for more than 90 days before using those funds to repay an existing bond issue. This technique allows issuers, often municipalities, to refinance debt ahead of schedule, typically to capitalize on lower interest rates or improve debt service flexibility. It's important to differentiate advance refunding from pre-refunding, which involves callable bonds issued closer to the redemption date.

Key Insights

• A bond is considered an advance refunding if issued more than 90 days before the older bonds it will retire are redeemed.
• Governments frequently use advance refunding to delay debt payments and ease budgetary pressures.
• Municipalities leverage advance refunding primarily to reduce borrowing costs by taking advantage of favorable interest rates.

How Advance Refunding Works

In corporate and municipal finance, refunding is the process of retiring existing callable bonds by issuing new bonds, often at lower interest rates, to reduce overall financing costs. The proceeds from the new bonds are placed in an escrow account, creating a sinking fund to pay off the original bonds when called.

With advance refunding, issuers hold the proceeds for over 90 days before applying them to repay outstanding debt. This approach is especially common when interest rates have dropped since the original bonds were issued, allowing issuers to refinance at more favorable terms.

Advance refunding bonds typically sell at lower yields than the refunded bonds. The funds raised are invested in secure government securities until the old bonds are called, ensuring timely repayment.

This method is akin to refinancing a mortgage, where borrowers replace higher-rate debt with lower-rate debt to save money over time. In 2017, advance refunding bonds accounted for $91 billion, representing 22.2% of the $3.8 trillion municipal bond market.

Regulatory Framework Governing Advance Refunding

Regulators have implemented rules to prevent potential misuse of advance refunding, especially since municipalities could exploit low tax-exempt rates to issue excessive debt and invest in higher-yielding assets. The Tax Cuts and Jobs Act of 2017 eliminated the tax-exempt status of interest on advance refunding bonds issued after December 31, 2017, curbing some of these risks.

State laws impose additional restrictions, including limits on maturities and interest rates. The IRS also regulates earnings on investments made with advance refunding proceeds to prevent arbitrage abuses. Typically, municipalities are allowed only one advance refunding per bond issue during its lifetime. Before proceeding, issuers must ensure that the anticipated savings justify issuance costs.

Advance Refunding in Action: A Practical Example

Advance refunding is particularly advantageous in low-interest environments. For instance, a city intending to refinance outstanding bonds at a lower rate would issue new refunding bonds and invest the proceeds in U.S. Treasuries or other secure government securities. These investments are held in an escrow portfolio, and the interest and principal generated are used to pay off the older bonds upon their call date, effectively reducing the city's interest expenses and improving fiscal stability.

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