Getting to Know Pre-Refunded Bonds

Key Points

  • Pre-refunded bonds are a type of municipal bond that are usually secured by high credit-quality investments.
  • Most, but not all, pre-refunded bonds have short maturities.
  • Pre-refunded bonds currently offer an after-tax yield advantage relative to other bonds of similar maturity and credit quality.

If you are looking for short-term, high-credit-quality investments, we believe you should consider pre-refunded municipal bonds—especially if you're in a high tax bracket. They offer attractive yields relative to other conservative investments, plus potential tax benefits similar to other municipal bonds. However, not all pre-refunded bonds—termed "pre-re's"—are short-term and they may carry additional risks compared to investing in other high-credit-quality investments such as a U.S. Treasuries.

Refundings have surged this year

Nearly 65% of municipal bonds issued this year have gone toward paying off municipalities' older, higher-interest-rate debt.1 The new bonds are known as "refunding" bonds, and their proceeds are used to pay off the older bonds, referred to as "refunded" bonds. Those bonds are either immediately  paid off, or paid off at a predetermined date.2

Bonds that are paid off at a predetermined date are called "pre-refunded" bonds, or "pre-re's." The old bonds, which have been "pre-refunded" with the proceeds of the new issue, remain outstanding—usually until the bonds' first call date if it has not already passed. To ensure timely interest and principal payment on the pre-refunded bonds, the proceeds of the refunding bonds are held in escrow and invested in very high credit quality investments—like cash or U.S. Treasuries. However, the proceeds may be invested in other securities that are not high credit-quality—such as corporate bonds. A pre-refunded bond's additional disclosures or escrow agreement will usually state the collateral.

To illustrate how pre-refunding works, assume that in 2013, a municipality issued a 10-year bond that paid a 4% interest rate and was callable—meaning it can be retired at the municipality's option—at any time after five years. Taking advantage of today's lower interest rates, the municipality issues a new eight-year bond in an amount that is sufficient to pay all of the remaining interest and principal on the original 2013 bond. Because the original 2013 bond is not callable for another three years, the proceeds of the new eight-year bonds are placed in escrow and invested in U.S. Treasury securities in amounts that perfectly match the 2013 bonds' scheduled interest and principal payments. For the next three years, proceeds from the Treasuries held in escrow will pay the interest and principal payments on the 2013 bonds.

In this example, the municipality benefits because they have lowered the interest rate on their debt. The investor may also benefit because they now own a bond with:

  • Higher credit quality than before because it is secured by U.S. Treasuries
  • A known maturity date, which can be a benefit for cash flow planning purposes.

Pre-refunded bonds may offer a yield advantage vs. other high credit-quality bonds

Because the proceeds of the refunded bonds are placed in escrow and invested, the pre-refunded bonds are securitized by those investments. Usually, the collateral for the pre-refunded bonds is U.S. government obligations—such as U.S. Treasuries, State and Local Government Securities (SLGS)—which are a special form of Treasury obligations—or U.S. agency bonds. Pre-refunded bonds are still municipal bonds and like most municipal bonds, interest is exempt from federal and potentially state income taxes. By investing in a pre-refunded bond, you are effectively investing in a tax-advantaged version of whatever the collateral is.

Yields for pre-refunded bonds are similar to yields on U.S. Treasuries, but coupon payments on pre-re's are usually exempt from federal and possibly state income taxes. After factoring in the tax benefits that pre-refunded bonds offer, yields are greater than Treasuries. Although U.S. Treasuries may collateralize a pre-refunded bond, it may contain slightly more risk than a U.S. Treasury because it is not a direct obligation of the U.S government and instead is held in an escrow account. However, if you are willing to accept this risk, you will likely be compensated for it.

Compare pre-refunded bonds to other high-quality bonds

Compare pre-refunded bonds to other high-quality bonds

Source: Barclays and Bloomberg, as of 8/27/2015.
Note: Pre-refunded muni yields are represented by the YTW on the Barclays 1 Year, 3 Year, and 5 Year Prerefunded Indices, respectively. After-tax Treasury yields assume 33% federal and 5% state tax rate.
Note: Yield difference may be due to the securities held as collateral for the pre-refunded municipal bonds or other characteristics.

Most pre-refunded bonds have maturities of less than four years

Because pre-refunded bonds are refunded to the bonds' next call date, often they have short maturities. In fact, 87% of the Barclays Prerefunded Index has maturities of less than four years. But not all pre-refunded bonds are short-term. Prior to considering a pre-refunded bond as an alternative for other high credit-quality bonds, ensure that the pre-refunded date matches your investment goals.

Pre-refunded bonds tend to have short-term maturities

Pre-refunded bonds tend to have short-term maturities

Source: Barclays, as of 8/21/2015.

What do you do if your bond gets pre-refunded?

A municipal bond that gets pre-refunded usually increases in price. This is because the maturity is shortened and it is often collateralized by high credit-quality investments—thus minimizing default risk. If your municipal bond gets pre-refunded, reevaluate it to determine if it still meets your investment objectives. You may already be invested in other short-term, high credit-quality investments and the newly pre-refunded bond may cause you to be overweight bonds with similar characteristics. If this is the case, consider liquidating and using the proceeds to invest in another security that meets your mandate.

What to do now

Yields for short-term bonds are at historically low levels—making every additional basis point count. We believe that pre-refunded bonds may be an attractive alternative to other short-term, high credit-quality bonds, especially if you factor in the potential tax advantages. You can search for pre-refunded bonds on Schwab.com or consult with your local Schwab Fixed Income Specialist for additional help.

Next Steps

Talk to Us
To discuss how this article might affect your investment decisions:
-          Call a bond specialist at Schwab anytime at 877-908-1072.
-          Talk to a Schwab Financial Consultant at your local branch.

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