Declining interest rates due to our lagging economy has many school districts wondering if they should refinance their debt. According to data obtained from the Michigan Municipal Advisory Council, 62 Michigan school districts issued a total of $1,050,650,000 in refinancing bonds in 2007.
Two key factors make a refinancing work - lower interest rates and the passage of time.
Interest rates are currently near 30-year lows. This reduction in interest rates produces refinancing opportunities. However, even without the reduction of rates, the simple passing of time can create refinancing opportunities. In general, the longer the maturity of the bonds, the higher the interest rate. Shorter term bonds typically have lower interest rates. Ten years after the original borrowing, the interest rate on a 20-year bond can be replaced with a 10-year bond interest rate.
Ironically, low interest rates can also inhibit refinancing opportunities. To understand this, it is important to be familiar with bondholders call protection and the two types of refinancings: current refinancings and advanced refinancings. In Michigan, most debt issuances are sold with 10-year call protection, meaning the bonds cannot be called (or redeemed) within the first ten years. This does not necessarily mean the bond issuance cannot be refinanced within the first 10 years. It does impact the type of refinancing.
Here are the two types of refinancings:
Current Refinancing: A refinancing bond issue which settles less than 90 days before the call date on the bonds being refunded.
Advanced Refinancing: A refinancing bond issue which settles more than 90 days before the call date on the bonds being refunded.
An advanced refinancing requires new bond proceeds to be held in an interest-bearing escrow account until the call date on the old bonds. The federal government allows issuers to earn up to the new bond yield (or “arbitrage yield”) on its escrow securities. When short-term interest rates are very low, and issuers cannot earn their “arbitrage yield” in the escrow, more funds are deposited into the escrow account, reducing the school’s savings. In a very low short-term interest rate environment, it may not be possible to earn the “arbitrage rate” in the escrow account. Therefore, the longer the time until the redemption date of the bonds to be refinanced, the less likely the refinancing will produce adequate savings. When considering an advanced refinancing, a school district must be sure the savings are adequate. It is also important to note that the IRS only permits one advanced refunding of a new money bond issue. However, bond issues can be refunded in a number of partial refunding issues.
As independent advisors to school districts throughout the county and the State of Michigan, schools frequently ask us if they should refinance their bonds. Here are some vital questions to review when considering a refinancing:
- Are we using the one advance refunding?
- Based on the remaining life of the old issue, how many more chances will we have to refinance?
- Will the refinancing produce at least 3% savings (or 2% savings for large issues or issues with very low interest rates)?
- Are the savings net of all costs of issuance?
- Are we saving at least as much as the costs of issuance?
- How will a refinancing impact the budget or debt millage in the short and long term?
- Can the refinancing assist in restructuring our debt to allow for new debt to be issued with little to no millage increase?
- What is the “Option Value” of refunding now versus waiting until a later date?
In summary, when considering a refinancing, a school district should take into account the options and benefits or consequences. No single magical threshold or savings level will work for every school district and every debt. We recommend that school districts talk with a qualified, independent advisor who will assist in weighing the information and determining if refinancing is right for them.