Bond Refinancing Thoughts

This content was originally published by Keygent Managing Member, Chet Wang.

Bond Refinancing Thoughts

Many school and community districts have previously issued bonds in a higher interest rate environment. With interest rates still near historic lows, opportunities to refinance (or refund) debt exist for many districts.

Industry Benchmarks Are Part of the Analysis

When is a good time to refund debt? While there are industry benchmarks, there are several other considerations which make refunding decisions case-by-case. The industry rule of thumb is a present value savings of at least 3%. Present value savings is calculated by discounting the debt service savings by the bond yield of the refunding bonds. Dividing this figure by the principal amount of bonds refunded results in the present value savings percentage.

Another industry rule of thumb is refunding efficiency of at least 50%. Approaches to this benchmark vary, but generally speaking, when the present value savings is higher than the escrow negative arbitrage, the 50% efficiency benchmark is met. Escrow negative arbitrage is the differential between the escrow investment rate and the refunding bond yield. As an example, if refunding bonds are issued in 2017 to refinance bonds with a redemption date in 2021, there is a 4-year escrow period. In the current interest rate environment, short-term rates are lower than long-term rates. For illustration, let’s say an escrow investment rate for the 4-year period is 1%, while the bond yield for the long-term refunding bonds is 3%. This 2% differential in dollars is the escrow negative arbitrage.

Qualitative Factors Are Important to Consider

Even if the 3% present value and 50% efficiency benchmarks are met, there are other important considerations to be mindful of:

  1. Staff time involved (which includes reviewing legal documentation, preparing Board materials, updating credit ratings, and participating in the bond pricing).
  2. Costs of issuance relative to savings.
  3. Potential public relations benefits. On this 3rd point, taxpayers love to save money, so if a district saved $1 million through a refinancing, there are opportunities to communicate to the public that the district is being a good steward of taxpayer dollars.

Some districts might believe that 5% is a more appropriate present value savings benchmark while others might believe that any amount of negative arbitrage is bad. All things considered, refinancing is a multi-faceted decision that involves both economic and qualitative variables.


Chet Wang

Chet Wang is a registered municipal advisor with an exclusive focus on California education municipal bonds.  He has provided financial advisory and investment banking services to California school and community college districts since 2005.