Waiting for the call date would save issuers millions

Advance refunding tax-exempt debt with taxable bonds prior to the call date does not always pay off, a new research paper shows.

Those are the findings of Andrew Kalotay, president of Kalotay Advisors, and Martin Luby, associate professor, public affairs, associate dean of academics at University of Texas at Austin. They released a paper on the subject Tuesday as part of the Brookings 12th ^{Annual Municipal Finance Conference that kicks off July 18.} 

The researchers analyzed 14 transactions between 2018 and 2020 and determined that the taxpayers would have come out half a billion ahead had the issuer waited out the call date instead of refunding their exempt bonds with taxable paper. The paper pegs the typical refunding efficiency or savings factor at roughly 70%, as compared to waiting until the call date. 

“Refunding is recommended only if the savings capture well over 90% of the value of the call option,” said Kalotay. “The efficiency of the taxable refundings was barely 70%. They were extremely speculative and turned out to leave a lot of potential savings on the table.” 

The researchers self-labeled their research as “counterfactual” as they explored what could have happened in a real world refunding episode. “We are hypothesizing what could have happened if the issuers waited until the call date and then refunded with tax-exempt bonds,” Kalotay said.   

The downside to waiting is a heightened risk factor if rates would rise, but the call option also has costs attached, they said. The paper concludes that some cost savings may be realized but they are outweighed by playing the waiting game. 

The research includes examples plucked from real life scenarios including financial maneuvers executed by the Massachusetts School Building Authority. On Nov. 20, 2019, the MSBA refunded its outstanding 2011 Series B Bonds callable at par on October 15, 2021. 

According to the paper, MSBA saved $121.63 million by advance refunding the 2011B Bonds with its taxable 2019 Bonds. But if they had waited until the call date in 2021 and then refunded with tax-exempt bonds, the issuer would have saved $221.63 million. The paper postulates that the Massachusetts taxpayers are on the hook for roughly $100 million in lost savings. 

The paper does not draw any correlation between the results and what effect the elimination of tax-exempt advance refunding has had on the muni market.  

Advance refunding using tax-exempt bonds was eliminated by the Tax Cuts and Jobs Act in 2017, to compensate for the loss of tax revenue caused by rate cuts. Muni market supporters have been laser-focused on bringing it back ever since. 

“My recommended solution is to issue non-callable bonds,” Kalotay said.

Cited examples back up the conclusions reached in the market. “I have a hunch that by now issuers have learned a painful lesson, and that’s why taxable advance refundings have dried up,” Kalotay said.