Pre-refunded municipal bonds offer short-term investors the ability to take advantage of the tax advantages of municipal bonds while gaining higher tax equivalent yields and avoiding some of the risks of downgrade or even default that municipal bonds inherently carry.
A pre-refunded municipal bond is a bond that the issuer has decided to redeem (call) from the bondholder prior to its maturity date. The early redemption feature is one that appears in most bond issues and is limited to specific dates outlined in the bond's prospectus. The call feature gives the issuer the ability to lower their overall interest expense by retiring existing bonds with high interest (coupon) rates. Most calls occur during periods of low and/or falling interest rates. A tax-free bond issuer will distribute new bonds at lower rates and pledge the proceeds of the new issue to retire (pre-refund) outstanding bonds at their earliest possible call date. In many instances, the issuer will use the proceeds of the new bond issue to purchase Treasury securities that mature in conjunction with the call date on the bond being retired. When this occurs, the pre-refunded bond is said to be "escrowed to maturity in government bonds" and as such takes on the credit quality of the underlying treasury security.
The buyer of an escrowed to maturity pre-refunded bond is picking up the credit quality of a government security with the tax-advantage of the municipal security. When you add these two features together, the safety conscious investor is provided with an investment vehicle that has the potential for providing a higher after-tax yield on a conservative and short-term investment.
In the current uncertain environment where investors are concerned about credit quality of municipals, the advantages here are quite obvious.
At the time of this writing, the yield on a two-year Treasury Note is below 2%. The investor must pay a federal tax on the interest income. By comparison, a municipal bond that has been "pre-refunded" to mature in two years may be yielding as high as 3% to call, and the interest earned on this security is exempt from Federal and State taxes. The benefit of the "pre-refunded" bond is not only a higher rate, but a lower tax obligation.
It is worth noting that pre-refunded bonds often trade at price premiums because they are bonds that the municipality has chosen to retire are usually those that bear high coupons. For this reason, it is important to look at the yield to call or prefunded date. Purchasing long-term municipal bonds that are near maturity in the secondary markets at a premium can provide tax losses on maturity, a positive tax attribute that can offset gains.
There are always risks to buying a bond at a premium – the greatest being the occurrence of a liquidation event meeting the requirements in the prospectus that would permit the issuer to refund the bond at par prior to prefunded date. Another consideration is that all fixed-income investments are interest rate sensitive. A change in market rates of interest may cause price fluctuations that could affect your return if the investment is sold prior term.