Bond refunding is the practice of issuing new bonds to pay off outstanding ones, most often to take advantage of lower interest rates. It works much like refinancing a mortgage: the issuer sells new debt at today’s rate, uses the proceeds to retire the older, higher-rate bonds, and captures the savings across the remaining life of the debt. For state and local governments, the mechanics changed significantly after Congress eliminated tax-exempt advance refunding at the end of 2017, and issuers have been working around that limit ever since.
Why Issuers Refund
Interest cost savings drive most refundings. When market rates drop below the coupon on outstanding bonds, replacing that debt at the lower rate produces real savings over time. Financial advisors typically want to see net present value savings of at least 3% of the refunded par amount before recommending the transaction, because the savings have to overcome underwriting fees, legal counsel, rating agency fees, and any call premium owed to existing bondholders. Those costs run higher as a percentage of the deal on smaller issues.
Rates aren’t the only reason. Some issuers refund to escape restrictive covenants in the original bond agreement, whether that means caps on future borrowing, required financial ratios, or limits on how assets can be used. Replacing the old bonds with new ones on looser terms frees the issuer to pursue projects or restructure without tripping a violation.
A third motivation is reshaping the debt maturity schedule. An issuer staring at a large balloon payment can refund and stretch the repayment across more years, smoothing annual debt service. An issuer with better-than-expected revenue can do the opposite and accelerate repayment to cut total interest. For governments that have to balance annually, that flexibility matters as much as the raw interest savings.
Current Refunding vs. Advance Refunding
The line between the two types is timing. In a current refunding, the new bond proceeds pay off the old bonds within 90 days of issuance.1Municipal Securities Rulemaking Board. Refundings and Redemption Provisions The old bonds are already callable or close to maturity, so the transaction is comparatively simple. Current refundings remain available to all issuers, including municipalities selling tax-exempt debt.
An advance refunding is any refunding where the new bonds are issued more than 90 days before the old bonds can be redeemed.2Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered to Be Tax Exempt Historically, issuers used it to lock in a favorable rate well ahead of the call date, parking the new proceeds in an escrow of Treasury securities until the old bonds became callable. Municipalities with call dates years out found this useful when rates dropped and they wanted to capture the savings without waiting.
What the 2017 Tax Law Changed
Section 13532 of the Tax Cuts and Jobs Act repealed the authority to issue tax-exempt advance refunding bonds after December 31, 2017.3Internal Revenue Service. Advance Refunding Bond Limitations Under Internal Revenue Code Section 149(d) Under 26 U.S.C. § 149(d) as it stands, interest on any bond issued to advance refund another bond does not qualify for federal tax exemption.2Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered to Be Tax Exempt
State and local governments now face a choice they didn’t have before. They can wait until the call date and do a current refunding, accepting the risk that rates rise in the meantime. They can issue taxable advance refunding bonds, which have to carry a higher coupon since investors can’t exclude the interest from income. Or they can use one of the alternative structures below. Bipartisan legislation to restore tax-exempt advance refunding has been introduced repeatedly, including the LOCAL Infrastructure Act in April 2025, but similar bills have failed in earlier sessions, so it isn’t something to plan around.4U.S. Senate. Bennet, Wicker Introduce Bipartisan Legislation to Reinstate Advance Refunding for State and Local Infrastructure Projects
Alternative Structures Municipal Issuers Use Now
Three workarounds have absorbed most of the volume that used to run through tax-exempt advance refunding.
Taxable advance refunding. The Section 149(d) prohibition applies only to tax-exempt bonds, so an issuer can advance refund by selling taxable bonds.3Internal Revenue Service. Advance Refunding Bond Limitations Under Internal Revenue Code Section 149(d) The cost is obvious. Because investors owe federal income tax on the interest, they require a higher coupon, which eats into the savings that motivated the transaction. This approach works only when the gap between the old bonds’ rate and current taxable rates is wide enough to swallow the tax-exemption premium.
Forward delivery bonds. A forward delivery bond is priced today but doesn’t settle until a specified future date, typically timed to land within 90 days of the old bonds’ call date so the transaction qualifies as a current refunding. The issuer locks in today’s rate without triggering the advance refunding rules. Investors charge a premium for committing capital to a future settlement, the contracts require extra documentation, and issuers pursuing this route usually need strong credit, often at least AA.
Crossover refunding. The issuer sells new bonds and escrows the proceeds, but the old bonds are not defeased. Until the call date, the issuer keeps paying debt service on the old bonds from its own revenue, while investment earnings on the escrowed proceeds cover interest on the new bonds. On the crossover date, the escrow pays off the old bonds and the issuer’s revenue starts servicing the new ones.5Internal Revenue Service. TEB Phase III – Lesson 1, Refundings Because the old bonds remain outstanding until the crossover, the legal and accounting treatment differs from a standard advance refunding with escrow defeasance.
Escrow and Defeasance
When the old bonds can’t be retired immediately, the proceeds from the new bonds go into an irrevocable escrow account, invested in U.S. government securities structured to mature on the dates the old bonds’ interest and principal come due, ending with the call date when the remaining old bonds are redeemed.
The arrangement produces what’s called defeasance, in two versions that matter both legally and financially. In a legal defeasance, the bond trustee or creditor formally releases the issuer from the obligation, and the debt is extinguished. Whether that’s available depends on the terms of the original bond indenture, and not every indenture allows it. In an in-substance defeasance, the issuer places enough risk-free assets in an irrevocable trust to cover all scheduled payments, but the creditor does not release the issuer. The debt is economically neutralized, though the issuer remains technically liable if the escrow ever fell short. That distinction has direct consequences for financial reporting.
Arbitrage Rules and Rebate
Federal tax rules exist to stop issuers from profiting on the spread between a low tax-exempt borrowing rate and higher-yielding investments. Under 26 U.S.C. § 148, a bond is an “arbitrage bond” if its proceeds are expected to be invested in securities that yield materially more than the bond itself.6Office of the Law Revision Counsel. 26 USC 148 – Arbitrage Any bond classified as an arbitrage bond loses its tax-exempt status under 26 U.S.C. § 103(b).7Office of the Law Revision Counsel. 26 U.S. Code 103 – Interest on State and Local Bonds
This bears heavily on refundings because the escrow account is exactly the kind of investment the rule targets. The escrow’s yield generally has to be structured not to exceed the bond issue’s own yield. Narrow exceptions exist for temporary periods, reasonably required reserve funds capped at 10% of proceeds, and a minor portion exception for the lesser of 5% of proceeds or $100,000.6Office of the Law Revision Counsel. 26 USC 148 – Arbitrage
Even when yield restrictions are satisfied, any excess arbitrage earnings have to be rebated to the U.S. Treasury. Rebate payments come due in installments at least every five years, each covering at least 90% of cumulative excess earnings to that date, with a final payment within 60 days after the last bond in the issue is redeemed.6Office of the Law Revision Counsel. 26 USC 148 – Arbitrage Issuers that owe rebate file IRS Form 8038-T with payment. Missing the deadlines can bring late interest penalties and, in serious cases, retroactive reclassification of the bonds as taxable.
What Refunding Means for Bondholders
Refunding is an issuer strategy, but investors feel it. The main effect is reinvestment risk. When bonds are called early, holders get their principal back ahead of schedule and have to reinvest at whatever the market offers, and since refundings happen after rates have fallen, that’s usually a lower-rate environment. That’s the same reason the issuer found the transaction worth doing.
Bondholders receive the call premium specified in the original indenture, which partially offsets the early redemption. Optional call provisions commonly let the issuer redeem at a specified price on or after a date roughly 10 years after issuance.1Municipal Securities Rulemaking Board. Refundings and Redemption Provisions Some bonds carry make-whole call provisions, which pay a lump sum calculated on a net present value basis to offset the lost interest.
Credit exposure also shifts. Once bonds are advance refunded and backed by an escrow of Treasury securities, the holder is no longer relying on the issuer’s ability to pay; the escrow provides the security. The MSRB notes that investors should still check whether any of the escrow securities themselves are callable, which can introduce reinvestment risk inside the escrow fund.1Municipal Securities Rulemaking Board. Refundings and Redemption Provisions
Accounting Treatment
How a refunding hits the books depends on who the issuer is.
Governmental Issuers Under GASB
State and local governments follow the Governmental Accounting Standards Board. Under GASB Statement No. 23, the difference between the reacquisition price paid to retire the old bonds (including any call premium) and the net carrying amount of those bonds is not recognized immediately. It is deferred and amortized as a component of interest expense over the shorter of the remaining life of the old debt or the life of the new debt.8Governmental Accounting Standards Board. Summary – Statement No. 23 On the balance sheet, the deferred amount is reported as a deduction from or addition to the new debt liability.
Corporate Issuers Under FASB
Corporations follow the Financial Accounting Standards Board. When a company extinguishes debt through refunding, the resulting gain or loss is recognized in the current period’s income statement. GAAP no longer uses the “extraordinary item” classification for these gains and losses; that concept was eliminated for fiscal years beginning after December 15, 2015. The gain or loss is now reported in ordinary income, though companies frequently disclose it as a separate line so investors can see the effect.
The treatment of in-substance defeasance also differs from what many assume. Under current FASB guidance, placing assets in an irrevocable trust to service old debt does not on its own let the issuer remove that debt from the balance sheet; the liability stays put unless the creditor formally releases the issuer through legal defeasance. Governmental accounting is more permissive here, which is one reason the escrow-and-defease model has been so central to municipal finance.