Scott Robertson - May 2012

When to Execute an Advanced Refunding: A Literary Interpretation

A famous song performed by Dinah Washington includes the verse – "What a difference a day makes". While the subject matter of the song is different from the performance of the financial markets over the past several years (love versus diabolical torture), we certainly see that the market is driven to and fro, on a daily basis, by events around the world. It is often clear that logic may not be the driving force as traders react to news which could be likened to a "herd" mentality.

Another factor we see in today’s market are low interest rates throughout the yield curve which are driving a flurry of current and advance refundings. Historically, financial advisors and underwriters have suggested to issuers that the benchmark for the decision making process should be that, if a minimum of 3% net present value can be achieved the financing should be executed. However, with short-term interest rates at such low levels, we find that in many advance refundings, even with 3% NPV savings or greater, there is significant negative arbitrage in the escrow (created by the disparity between the yield on the bonds (long-term rate) and the escrow investments (short-term rate)). This negative arbitrage represents an opportunity cost to the issuer in advance refunding bonds and should be a consideration in evaluating refunding opportunities.

Some industry participants will attempt to convince issuers to pursue an advance refunding, despite the inherent opportunity costs and the presence of significant negative arbitrage by quoting John Ray’s expression from his "A Hand-book of Proverbs, circa 1670" stating "A bird in the hand is worth two in the bush". The origin of this phrase refers to the practice of falconry where the falcon (the bird in the hand) was more valuable than the two in the bush (the prey). This understanding of the falcon’s presence makes the argument of one in the hand versus two in the bush much more meaningful. I would suggest that what an issuer has "in hand" is its version of a falcon (bonds) that it can use to find the prey (interest cost reduction). The goal, however, is not to find a pair of sparrows but to leverage the falcon’s hunting ability to find a siege of herons.

Negative arbitrage is like an albatross – to use a phrase from the poem "The Rime of the Ancient Mariner" by Samuel Taylor Coleridge. In the poem an albatross was hung around the mariner’s neck as punishment for killing the defenseless bird. In the poem, as in an advance refunding, once the "deed is done" there is no turning back – in other words, you can only advance refund any series of bonds once. Negative arbitrage remains after the closing and weighs down the potential benefits of the transaction.

With that said, if an issuer is presented with advance refunding opportunity with NPV savings well in excess of 3% there are tools that it can use to determine if the number of "birds in the bush" to be had outweigh (no pun intended) the "albatross" of negative arbitrage. Here are some for future reference: