Refunding, Conversion, and Defaults

Issuing new bonds to retire outstanding debt is called "refunding." Refunding bonds can result in savings if the interest rate on the new bonds is lower than the interest rate on the existing bonds. Refunding bonds can be used to remove restrictive bond covenants that apply to existing bonds. Local governments also can use refunding bonds to restructure debt service payments.

Refunding bonds have the same types of issuance costs as a new issue, thus the government in essence repeats these costs during the life of the debt. Advance refundings can be done only once during the life of a bond, so the issuer must identify the most advantageous time to refund. Advance refundings are not allowed for private activity bonds.

The refunding bonds may be sold for cash and the outstanding bonds redeemed in cash, or the refunding bonds may be exchanged with the holders of the outstanding bonds. In the case of financial difficulties, such as default, a refunding plan is part of the reorganization of debt that may be mandated and supervised by the courts.

Refunding Callable Bonds

Lower interest rates are the most common reason for refunding--sometimes referred to as a high-to-low refunding because of the conversion from a high interest rate bond to a low interest rate bond. Refunding is generally developed through the issuer's exercise of the call provision that was incorporated into the original bond issue. When outstanding bonds bear interest rates substantially higher than those currently obtainable in the municipal bond market, it may be appropriate to determine whether a refunding can be carried out to the advantage of the issuing government--either of the full amount outstanding or some portions thereof.

Bonds may be issued with the provision that they may be "called" for payment prior to their maturity date. Bonds may be made callable at any time after the date of issue; in practice, however, the call normally is exercised with appropriate notice only on interest payment dates. A bond issue may be made part callable and part noncallable. Bonds may be made callable at par or at a premium.

Callable bonds may afford greater flexibility in the jurisdiction's debt structure. If the initial retirement schedule provides too rapid, or a period of declining revenues is encountered, bonds may be recalled and refunded at the most favorable terms. During periods of high interest rates, the call feature permits bonds to be issued and then refunded at lower rates at some time during their term if the market changes or the jurisdiction's credit rating improves. The callable feature permits debt retirement to be accelerated if the project's revenue capacity expands.

Bonds issued within 90 days of the call date of the outstanding bonds are called "current refunding bonds." Relatively few limits are placed on current refundings. If the bonds are issued more than 90 days in advance of the call date, the bonds are called "advance refunding bonds." There are numerous federal restrictions on the use of advance refunding bonds because of arbitrage earnings restrictions.

Since most investors insist on a premium for callable bonds, the resultant net savings must be carefully considered. The steps required include a determination of:

(1) The probable interest rate that could be achieved on the refunding bonds if offered in the prevailing market;

(2) The gross amount of interest to be saved in terms of: (a) current dollars payable in the years in which the savings will occur; and (b) present worth of dollars to be saved at future dates; and

(3) The cost of refunding--the call premiums payable and the costs incident to the issuance of refunding bonds.

The apparent difference between gross interest costs on the old and new bonds, after allowance for the refunding costs (including all premiums) is not the most critical consideration. Failure to reduce all factors to a net present worth can result in a refunding which is apparently favorable but which, in fact, is disadvantageous to the issuing jurisdiction. [8]

Refunding to Adjust Contract Terms

Revenue bond issues often involve complex and lengthy indentures. It may become necessary to issue additional debt at some time prior to the maturity of the outstanding bonds. However, the terms of the existing contract may unduly restrict the issuance of new bonds. The restrictions may have been appropriate to carry out the original financing, but under the current conditions, they impede the accomplishment of the present objectives. Therefore, the issuing authority may find it desirable to arrange for the refunding of the outstanding debt in order to eliminate or modify the restrictive covenants.

Refunding to eliminate restrictive covenants frequently results in substantial additional costs. This fact underlines the importance of holding the restrictive elements in each bond indenture to a minimum, consistent with the original intent of the bond issue.

Refunding to Consolidate Debt

It may be possible to use refunding to consolidate the outstanding debt (or some portion thereof) a jurisdiction. To illustrate this approach, assume that a major expansion must be made to a city's sewage treatment facilities to be in compliance with revised state and federal standards regarding effluent discharges. The Sewer and Water Commission and City Council agree that an adjustment should be made in the sewer service charges sufficient to meet the debt service.

In Exhibit 7, it is assumed that the annual yield from the authorized increase in sewer service charges will be $1 million, with an estimated increase in this yield at a compound rate of 2% per annum. The city still has $6 million in bonds outstanding from a previous issue for the sewer treatment system, bearing a 5% interest rate and maturing serially in annual amounts of $500,000. The new sewage treatment facilities will cost $8 million with the new bonds proposed to be issued for 30 years with a uniform coupon rate of 5%.

It would not be possible to finance additional bonds under these conditions because the debt service in the first year would be $800,000 on the old bonds and $520,000 on the new bonds. Thus the total debt service would exceed the total available revenues for the first year of $1,000,000.

The refunding of the outstanding bonds along with the issue of new bonds might be a viable approach. The total funding required to achieve this consolidation is $14,200,000, including the refunding costs of $200,000. One plan for accomplishing the consolidation is shown in Exhibit 7. In year 1, the 5% interest rate is applied to the outstanding principal of $14.2 million, resulting in an interest payment of $710,000. This interest payment would leave $290,000 from the $1 million in annual revenues dedicated to debt service to be applied to reduce the outstanding principal. In year 2, the 5% interest rate is applied to the outstanding principal of $13.91 million, resulting in an interest payment of $695,500, leaving $324,500 from the $1.02 million in annual revenues to be applied to reduce the outstanding principal. As the annual revenue increases (at 2% per year), the funds available to reduce the outstanding principal increase, and therefore, the decrease in the annual interest payments is accelerated.

Exhibit 7. Consolidation of Existing & Proposed Debt Through Refunding

The Refunding Process

After the sale of the refunding bonds, the proceeds are held in an escrow account until the prior bonds are called. New bonds are issued in an amount sufficient to cover the principal, interest, and call premium of the prior bond issue. If the proceeds are invested in secure investment vehicles, the original bonds are considered "defeased" and are no longer considered a liability of the issuer.

Secure investments include cash, U.S. Treasury notes, or other obligations guaranteed by the U.S. government. Additionally, the rating on the original bonds is upgraded to AAA, since there is a guaranteed source of repayment. The escrow fund is used to meet debt service obligations of the original bond issue until the call date, at which time the remainder of the escrow fund is used to redeem the outstanding bonds.

Refunding issues do not have to go through the same legislative and/or constitutional approval process as the original bonds since the original bond issue was already approved. There is no limit as to how far in advance refunding bonds can be issued. Refunding issues are typically sold through a negotiated sale because of their complexity.

Bond issuers generally target a level of present value savings, measured as a percentage of the refunded bond issue as a guideline for determining when to issue refunding bonds. For example, 4% or 5% is a common target. The amount of money saved from refunding depends on several factors, including:

o difference between the prior and new bond interest rates;

o maturity date of the prior bonds;

o call date on the prior bonds;

o yield on escrow investments;

o call premium on prior bonds; and

o costs of issuance for the refunding bonds.

The earlier a bond issue is refunded, the greater the issuer's savings. Once the first call date on a bond issue has passed, an increasingly lower current interest rate is required on the refunding bonds to achieve a target level of savings. Smaller issues or specific maturities of an issue may not be worth refunding, even if the percent savings targets are achieved, if the absolute dollar savings are insufficient to justify the time, expense, and effort of executing a refunding issue.

Refunding Mature Bonds

The practice of refunding mature or maturing bonds should be avoided if at all possible, and if necessary, should be undertaken with great discretion. Conditions may arise, however, that force refunding to eliminate irregularities in the existing debt schedule. Such irregularities result from overly optimistic retirement schedules or from sudden shifts in economic conditions beyond the local control that lead to changes in the municipality's revenue system. Refunding may also be preferable to emergency borrowing, particularly when a good credit relationship has been established in connection with outstanding debt.

Refunded bonds should be scheduled into the debt retirement program as soon as possible within the jurisdiction's fiscal capacity. An excessively long retirement period might seriously limit future borrowing. On the other hand, the retirement period of the refunding bonds should be of sufficient duration to avoid the need for further refunding.

Forced Refunding

Refunding to restructure debt service is often used by a government during a recession in order to defer or stretch out debt service obligations until its financial situation improves. At times, a municipality may find it absolutely necessary to refund outstanding debts to avoid default on bonds or serious disruption of fiscal operations. Unfortunately, such forced refunding often encountered unfavorable market conditions, since the economic factors that give rise to the need for refunding may be widespread. This situation confronted many cities during the depression years of the thirties. Under such circumstances, a municipality--unable to sell refunding bonds to new investors--may be forced to negotiate with existing bondholders for the exchange of their holdings for new maturities. Since bonds may be widely held and bondholders difficult to locate, this undertaking can be a most cumbersome, particularly if the issue has turned over in the secondary trading market.

Forced refunding should never be unduly postponed. It is a matter of good fiscal administration to anticipate such emergencies and to take the necessary steps with sufficient lead time to resolve the problem in an orderly and businesslike manner. A frank and open presentation of the municipality's fiscal problems is necessary to secure understanding and cooperation from major bondholders.

Sale of Refunding Bonds

Five elements need to be considered: (1) the timing of the sale, (2) the maturity schedule of the refunding bonds, (3) the time of settle-ment on the new bonds, (4) the refunding costs, and (5) the redemption provisions for the refunding bonds. The security pledged in support of the refunding bonds should be the same as the original issue. Maturities may have to be rearranged to accommodate higher coupon rates on early maturities, or a rate limitation may have to be placed on those maturities to bring the debt service within the bounds determined in the planning of the issue. It may be appropriate to accelerate the maturity schedule on the refunding bonds to increase the interest savings at some future date. Such an acceleration is desirable if the issuing jurisdiction can afford to pay the refunding costs from current funds and is willing to forego the realization of the savings for a number of years.

Settlement on the refunding bonds should be a few days in advance of the due date on the called bonds in order that the issuing jurisdiction may be assured of having the cash in hand to meet the requirements for paying off the called bonds. Assuming no debt limit problems, the jurisdiction may prefer to complete settlement on the refunding bonds prior to the issuance of the call of the outstanding bond. This procedure is particularly appropriate in cases in where the likelihood of litigation might delay the delivery and settlement of the refunding bonds beyond the date for the redemption of the old bonds. While prior settlement involves the payment of overlapping bond interest, the net amount of such duplication can be reduced through short-term investments of the revenue from the new issue.

If state laws permit, it might be appropriate to increase the amount of the refunding issue by the amount of the refunding costs. While this approach reduces the net savings in current dollars, it should have little effect on the overall savings realized in terms of present worth dollars.

Including a call option will increase interest costs and thereby, decrease the amount of interest savings that can be attained. On the other hand, a call option on bonds that will mature in several years (e.g., at least five) may be justified if the refunding is in a market of medium interest rates.

Advanced Refunding

In the early 1960s, some jurisdictions engaged in the practice of "advanced refunding," that is, refunding bonds to take advantage of falling interest rates. Some jurisdictions had three sets of bonds outstanding on the same project--the original bonds, an initial set of refunding bonds, and a secondary set of advanced refunding bonds issued to refund a portion of the first set of refunding bonds. The effect was to have three sets of tax-exempt interest being paid on the same basic improvement. However, in August, 1966, the U.S. Treasury ruled that the interest on such bonds would not be considered tax-exempt:

1. Where all or a substantial part of the proceeds of the issue (other than normal contin-gency reserves such as debt service reserves) are only to be invested in taxable obliga-tions which are, in turn, to be held as security for the retirement of the obligations of the governmental unit.

2. Where the proceeds of the issue are to be used to refund outstanding obligations which are first callable more than five years in the future, and in the interim, are to be invested in taxable obligations held as security for the satisfaction of either the current issue or the issue to be refunded.

Defaults

No matter how satisfactorily resolved, defaults are likely to result in a decline in the jurisdiction's credit standing, producing skepticism among lenders and major difficulties in negotiating favorable interest rates on future bond issues. Even temporary defaults, if allowed to extend beyond the normal 90-day grace period, may result in the removal of a city from the listing of securities approved for fiduciary investments.

By far the largest number and most severe municipal defaults took place during the depression era from 1929 through 1938. The total debt of all governmental units whose defaults were recorded during this period was approximately $5.5 billion, or approximately 30 percent of the average net municipal debt outstanding at the time. The most prominent default of this period was that of the City of New York, with total indebtedness of slightly over $2.5 million. Lasting only a few days, the New York City default involved some general obligation notes issued in anticipation of delinquent tax collections. The $5.5 billion figure included approximately $160 million in default by the state of Arkansas, $190 million in default by local governmental units with less than 5,000 population, and $400 million in default by special purpose and special assessment districts.

Prior to the depression, municipal debt had increased at a very significant rate, in large measure, due to speculative overdevelopment of real estate in the twenties and the lack of realistic debt limits. In some cases, the officers of real estate companies became municipal officials and promoted bond issues to enhance their real estate holdings. Special assessment or local improvement districts often were created to finance the improvement of undeveloped and speculative areas. The issuance of debt in the name of an overlapping unit made debt limits ineffective.

The capacity of local government to pay these debts did not increase nearly as rapidly as the debts themselves. Municipal revenues rapidly declined as wealth, income, and assessed values plunged downward in the early years of the depression. The decrease in local tax revenues, for which there were no adequate substitutes, was not accompanied by commensurate declines in expenditures. Many governments were faced with rising debt service charges, the results of unwieldy debt structures contracted in the past, and with increased demands for unemployment relief payments.

Encouraged by the availability of capital at fairly low interest rates in the late twenties, many municipalities with unbalanced budgets were able to borrow enough to cover their operating deficits. This borrowing added to the already large fixed charges of many communities. In 1932 and 1933, however, municipal borrowing was greatly curtailed as a consequence of rapidly rising interest rates, bank failures, and the loss of public confidence in municipal bonds. Therefore, many local governments with deficit budgets were forced to default.

The defaults of the Depression led to the enactment of the Federal Municipal Bankruptcy Act. Under this act, any local government that has defaulted on its debt because of its inability to meet its commitments can apply for relief to the applicable Federal District Court which can approve a plan for the reorganization of the debt of the issuer. After the Second World War, several large bond issues to finance toll roads ran into difficulties in terms of covering debt service payments from net earnings. Such entities as the West Virginia Turnpike and the Calumet Skyway were eligible for reorganization under the Federal Municipal Bankruptcy Act; however, they did not resort to this course of action, relying on more conventional refunding procedures instead.

Types of Defaults

Minor or temporary defaults involve failure to meet the maturity payment of a single security or temporary postponement of interest payments. Such minor defaults may be the result of unanticipated declines in revenue collections, the shutting off of normal lines of bank credit, and/or a temporary inability to market refunding bonds. They usually can be corrected without disturbing the general debt structure or further interrupting debt service. Adjustment strategies include: (a) pay-ment during the grace period from belated tax receipts; (b) short-term bank loans; (c) small issues of refunding bonds; or (d) security exchanges. This latter strategy is particularly effective for relatively recent bond issues. Bondholders are contacted and negotiations are conducted to effect an exchange of outstanding bonds for new securities that more closely fit the community's long-term ability to pay.

A second, more serious class of defaults involves municipalities that have encountered such fiscal problems as peak debt service in period of low-paying capacity, serious breakdowns in the local economic base, and/or abnormally high tax delinquency. Under such circumstances, the municipality may experience difficulties in meeting current accounts as well as long-term obligations. Adjustments usually are effected by refunding or partial refunding a few years' obligations in order to free up some fiscal resources to meet current operating costs. It may be possible to accomplish this adjustment without a major disturbance of the general debt structure and without any scaling of debt. Once current obligations are returned to a more balanced basis, attention can be redirected toward long-term obligations that may require further readjustments to reflect sound principles of debt administration.

The third class of debt involves situations in which the jurisdiction is confronted by abnormally high debt, severely curtailed revenues, and significant accumulation of operating deficits, with little or no prospect for correction except through a comprehensive refunding plan. Such a plan usually involves a complete reconstruction of the entire debt retirement schedule and a scaling down of interest and even principal payments.

Scaling of debt involves the actual reduction in the jurisdiction's commitments and becomes necessary when the total obligation is clearly beyond the local government's capacity to pay. Investors naturally are reluctant to forego any portion of their contractual rights and particularly so with regards to principal. Unless the situation is hopeless, they tend to prefer extensive postponements, with the expectation that subsequent community growth and development will eventually bring protection to their investment. Thus, when necessary, scaling can be more readily accomplished through a reduction in interest rates.

Steps in Readjustment

Insofar as possible, the jurisdiction should take the initiative in readjustment and in planning and implementing the refunding plan. While serious defaults require time for careful deliberation before commitments are made, by exercising such initiative, the jurisdiction may gain the necessary cooperation from investors to successfully resolve the pending financial crisis. Attempting to cover up the fiscal crisis merely exacerbates the uncertainty, increases expenses, and ultimately may result in the municipality being placed in receivership. At this point, local officials no longer can control the readjustment process.

When it is evident that readjustment is unavoidable, an official statement should be issued to the municipality's creditors, giving notice of its inability to meet its obligations, identify the causes and probably duration, and outline the steps contemplated to correct the situation as expeditiously as possible. Municipal records should be opened to bondholders, and a summary analysis should be distributed, outlining the municipality's financial status and capacity to pay. This analysis should be followed by frequent reports of financial and economic conditions and trends. Only by such means can the municipality retain the initiative and assure the most constructive negotiations with its creditors.

A complete investigation of all relevant factors--financial, administrative, and economic--is a prerequisite to the planning of corrective action. Reliable experts should be consulted and a competent fiscal adviser retained. The relationship between outstanding obligations and normal capacity to pay must be ascertained, and operating costs should be examined to determine if they afford any basis for adjustments. The municipality must evaluate its financial status and relation to resources and liabilities, both immediate and future. In short, the municipality should approach its creditors with full knowledge of where it stands and of the reasonable expectations regarding the capacity to recover from its financial difficulties.

To be successful, the refunding plan must provide: (1) mechanisms to release current accounts from accumulated deficiencies; and (2) financing procedures that will assure the maintenance of balanced operations. While a brief hiatus from full debt service obligations may be necessary, such postponement is valid only if it is used as a means of systematically adjusting current accounts. Such refunding as is necessary should postpone the retirement of as little debt service as possible. The replanning of the debt structure should not trade a difficult immediate situation for an impossible future one. Callable bonds should be used to the extent possible to permit the re-refunding at lower interest rates if justified by market conditions, as well as the potential of accelerating the retirement process when conditions improve.

Adjustment of serious defaults, at best, involves a process of compromise, in which there is little opportunity for impartial settlement. Furthermore, refunding arrangements may contain the potentialities for recurring financial difficulties for several decades in the future. The experiences of many communities in the thirties offer ample support for the necessity of sound debt policies.

The procedures of refunding and the safeguards against defaults should be clearly understood by local officials. Most states have adopted legislative measures to circumvent the financial catastrophe faced by many governments in the thirties. The ultimate responsibility, however, still rests with local officials to adopt debt administrative procedures that will protect their community from "mortgaging its future."

Endnotes

[6] Municipal bonds often are underwritten by large investment syndicates that provide the funds to the issuing jurisdiction and, in turn, reoffer the bonds to individual investors. For a discussion of the underwriting of municipal bonds, see Alan Walter Steiss, Local Government Finance (Lexington, MA: D.C. Heath, 1975), Chapter 7.

[7] Underwriters of municipal bonds must perform several calculations on the stated interest rates to determine a net interest cost (the bid that they will make on the bonds). Net interest cost equals the total cost of interest over the life of the bond issue (less any premiums) divided by the total number of "bond years"--that is, the sum of the number of years to maturity for each separate bond.

[8] Lennox L. Moak, Administration of Local Government Debt, (Chicago, Ill.: Municipal Finance Officers Association, 1970), pp. 400-416.

[9] Refunding merely to effect a temporary tax reduction has no justification. The motivation is usually political. In some flagrant cases, bonds have been refunded just prior to elections to "improve" the record of incumbent office holders even though existing debt commitments could be readily met under the established schedule. Such practices result in unstable fluctuations in the tax levy, rising debt trends, and serious disruptions of the jurisdiction's debt structure.