How to Analyze Refunded Municipal Bonds
Sylvan G. Feldstein, Ph.D. Director, Investment Department Guardian Life Insurance Company of America
While originally issued as either general obligation or revenue bonds, municipals are sometimes refunded. A refunding usually occurs when the original bonds are escrowed or collateralized by either direct or indirect obligations or by those guaranteed by the U.S. government. Sometimes the escrows for the refunded bonds are allowed to hold lesser credit worthy investments.
The maturity schedules of the securities in the escrow fund are such so as to pay when due bond, coupon, and premium payments (if any) on the refunded bonds. Once this cash flow match is in place, the refunded bonds are no longer secured as either general obligation or revenue bonds. They now have a new security: the escrow fund and the securities that it contains. Such bonds, if escrowed with U.S. government securities, have little if any credit risk. They are the safest municipal bond investments available.
This chapter provides the analytical framework for determining the structure and credit quality of municipal bonds that have been refunded. Refunded bonds are discussed in terms of (1) the general structure of an escrow fund; (2) the reasons why bond issuers refund their bonds; (3) the two major types of refunded bonds; and (4) how the analyst or investor should determine the degree of insulation from adversity of an escrow fund and, thereby, the creditworthiness ...

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