A recent study has revealed that a popular bond refinancing tactic used by US states and cities has cost taxpayers billions of dollars. The research, which will be presented at the Brookings Institution's municipal finance conference, analyzed 14 advanced refundings between 2018 and 2020, in which tax-exempt municipal bonds were refinanced with taxable debt.
According to the study, these 14 borrowers alone, including the state of California and the New York State Thruway Authority, missed out on approximately $580 million in savings by choosing to refinance early instead of waiting until the call date when they could have used tax-exempt bonds with lower yields. When considering all the transactions over this period, the total savings lost is likely to amount to billions of dollars.
The decision to proceed with taxable advanced refundings was driven by concerns over rising interest rates. However, the Federal Reserve's decision to cut interest rates to zero amid the Covid-19 pandemic caused rates to fall even further, resulting in significant losses. Andrew Kalotay, president of Kalotay Advisors and one of the study's authors, noted that issuers speculated and lost a substantial amount of taxpayer money.
Municipalities, however, dispute the findings of the study, stating that it fails to consider the Federal Reserve's response to the pandemic and overlooks more favorable deals. For example, the Massachusetts School Building Authority issued taxable bonds in 2020 with a yield of 1.75% to advance refund debt issued in 2012. If they had waited until the bonds were callable in 2022, tax-exempt yields would have been about 2.25%.
In order to lower borrowing costs or defer debt payments, states and cities often undertake advance refundings, issuing new bonds before the existing ones can be redeemed. Historically, tax-exempt debt was used for these advance refundings, but in 2017, the Republican Tax Cuts and Jobs Act prohibited the sale of tax-exempt bonds for this purpose. As a result, municipalities turned to taxable bonds, issuing around $116 billion of them for advanced refundings between 2018 and 2020.
The research suggests that if issuers had compared the estimated savings of their advanced refundings to the value of the call options they would forfeit, they could have made better decisions. The study concludes that municipalities should not refinance early unless the savings ratio is at least 90%. However, the efficiency of the typical taxable refunding was found to be only around 70%.
While it is acknowledged that no one can predict where interest rates will go, the authors argue that mathematical analysis can be used to assess the probability of different outcomes. This could help municipalities make more informed decisions regarding refinancing options and avoid significant losses in the future.