Breaking a Bond

Advanced refundings are on the line as the federal government sees revenue in cutting off some muni bond tax breaks.
March 2005
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Once again, tax-writing committees in Congress have the tax-exempt municipal bond in their crosshairs. Although going after the bonds has been a hobbyhorse for the U.S. Treasury and congressional committees over the years, serious threats have been at a minimum for the past decade. But the perilous state of federal revenues is starting the search for more money. Closing sundry loopholes is a step that involves "enhancing" revenues without raising tax rates. So, tax breaks for state and local securities via exemption from federal taxes have popped back on the tax collectors' screen.

The latest assault comes in the form of a report from the U.S. Congress's Joint Committee on Internal Revenue and Taxation, which was commissioned to review tax preferences that might help close the federal government's $400 billion-plus deficit. Of the $311 billion in potential savings the Joint Committee targeted, municipal bonds accounted for $14 billion over 10 years. About $4 billion would come from restricting use of muni bonds for stadiums for private sports teams, by Indian tribes and in bond pools and closing some specialized tax treatments given to corporate holders of tax-exempt securities. The big enchilada in pumping up federal revenues to the tune of $10 billion is the proposed banning of advanced refunding, a tool governments use to lower their interest costs and, in the past few years--and somewhat controversially--to help them slide over fiscal rocks.

The mechanics of advanced refunding, while brain-splittingly complicated in practice, are pretty straightforward in concept. State and local governments issue refinancing bonds at a lower interest rate than existing bonds and use those proceeds to make financial investments in escrow accounts that offset the outstanding debt, thus lowering the overall cost of borrowing. So, if I originally borrowed at 5 percent and rates dropped to 4 percent, I would now borrow at 4 percent and earn 5 percent on the investment used to offset the old debt, thus lowering my interest cost to 4 percent. This happy result is often possible because the investments are made in taxable obligations--U.S. Treasuries--while the borrowing is done at tax- exempt rates. This can only be done before the old bond is callable.

Until the old bonds are called, however, the issuer ends up with twice as much outstanding tax-exempt debt in the market, and it is that increase in tax shelter that upsets the federal tax collectors. At present, issuers are permitted one bite on the advanced refunding apple. The Joint Committee proposal is to do away with it, and thereby limit the amount of tax-exempt debt outstanding.

Analyzing the economic and fiscal impacts is heavy stuff. While the added supply of tax-exempts due to advanced refundings does push up tax-exempt interest rates, the increased supply engenders more demand for U.S. Treasuries, driving down interest rates on them. Whatever the bottom line of the fiscal pros and cons, there is no doubt that the ability to advance refund has been an important tool for state and local governments, especially when the economy is down and times are tough.

In 2003, refundings (a large part of which are advance refundings) made up $120 billion of the $385 billion municipal bonds that were issued, and those numbers are likely to be similar for 2004. What has happened is that in times of economic downturn when revenues are dropping off, interest rates plunge. This in turn means that refunding opportunities increase and the market for advance refundings boils. As in the case with home-mortgage refinancings, issuers design refunding bonds so that they bring forward the savings in interest rates to the present period. These "scoop" refundings that yield upfront savings have provided major chunks of cash to governments over the past three years of low interest rates, in effect covering operating deficits.

This ability by governments to offset drops in revenues by refinancing debt allows them to keep up their spending in down cycles. Since the governments are able to pay salaries and make purchases, that keeps demand going in recessionary periods, which is what counter-cyclical spending is all about.

Now, all of this is not without controversy. There are those who see any device that helps a government get up off the mat as one that thwarts starving of the beast. But many more see that state and local governments are in a period of difficult fiscal adjustment as federal spending, including federal aid, becomes ever more restricted. On every front, states and localities are under assault and their fiscal options are increasingly pruned away and made less attractive by federal policy. Advanced refunding, while capable of some mischief if used unwisely, is a valuable tool that helps governments stay afloat in lean times and keeps the overall economy from deeper dives. Thus, it might be best to look at these preferences in terms of who gets helped and just when that help is given.