Is prerefunded muni bonds similar to callable muni bonds except the its holders do not face reinvestment risk? I still don’t understand why these bonds need to be refunded if not due to the declining interest rate? The escrow fund set up for prerefunding has to be guranteed by US government?
A pre-refunded muni bond probably is a callable muni bond, but it’s prerefunded because the issuer wants to call it and issue another bond instead. The issuer issues a new bond, and invests the proceeds waiting to call the muni. However, since the muni bond has tax advantages the issuer can’t just go invest in Treasury debt or you would have a really excellent way of tax advantaged investing in Treasury debt. Instead, the issuer escrows the money in Treasury debt that is specially issued for this purpose and pays lower interest. Prerefunded debt is AAA paper because it has these funky Treasuries escrowed to pay it off.
A bit convoluted for me… Ok, if the issuer needs the proceeds for a new bond, would it be easier just to call the old one? What would be the incentive to go the escrowing route? If I am an investor, why would I want to invest in the issuer’s escrow fund (which if composed of T-debt) if I can invest directly in Treausry debt myself?
It would be easier if he had the cash on hand to refund the old issue but alas most issuers of muni debt don’t have cash on hand to refund the old bond until they sell a new one. As an investor you would invest in prerefunded bonds if you were looking for a short term, tax advantaged risk-free investment. People have different tax brackets and prerefunded munis might have a different after tax yield for you than Treasury debt though they have the same credit quality (also they would not be anywhere near as liquid so you would get a liquidity premium).
I see. Liquidity premium? Sounds sweet. Then that makes sense now. Thx, Joey.