Bond refunding is the practice of issuing new bonds to pay off outstanding ones, most often to capture a lower interest rate, loosen restrictive covenants, or reshape a repayment schedule. The mechanics work much like refinancing a mortgage: sell new debt at today’s rate, use the proceeds to retire the old higher-rate debt, and keep the savings over the remaining term. For state and local governments, the practice changed sharply at the end of 2017, when Congress eliminated the ability to advance refund tax-exempt bonds with new tax-exempt debt. That single change reshaped how municipal issuers approach refundings today.
Why Issuers Refund
Interest cost savings drive most refundings. When market rates drop below the coupon on outstanding bonds, replacing them with lower-rate debt produces real savings over the life of the issue. Financial advisors generally want to see net present value savings of at least 3% of the refunded par amount before recommending the transaction, because savings have to clear the costs of issuing new debt: underwriting fees, legal counsel, rating agency charges, and any call premium owed to existing holders. Those costs run higher as a percentage on smaller deals.
Rates get the attention, but covenant relief is often just as valuable. An original bond agreement may cap future borrowing, require specific financial ratios, or restrict how the issuer uses its assets. Replacing those bonds with new ones carrying looser terms gives the issuer room to pursue capital projects or restructure operations without tripping a covenant.
Reshaping the maturity schedule is a third motive. An issuer staring at a balloon payment in a single year can refund to spread repayment over a longer period and smooth annual debt service. An issuer with stronger-than-expected revenue might refund to accelerate repayment and cut total interest paid. For local governments that must balance budgets every year, that flexibility can matter as much as the headline rate savings.
Current Refunding vs. Advance Refunding
The split between the two types comes down to 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 either already callable or close to maturity, so the issuer retires them almost immediately. Current refundings remain fully available to every type of issuer, including municipalities issuing tax-exempt debt.
An advance refunding happens when 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, municipalities used advance refundings to lock in a favorable rate well before a call date, parking the new proceeds in an escrow of Treasury securities until the old bonds became callable. That let them capture savings from a rate drop years before they could actually retire the old debt.
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 reads now, 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
That left state and local governments with three practical choices: wait until the call date and do a current refunding (and accept the risk that rates rise in the meantime), issue taxable advance refunding bonds (and absorb the higher borrowing cost that comes with taxable interest), or use one of the alternative structures below.
Bipartisan bills to bring the tool back have been introduced repeatedly. In April 2025, Senators Bennet and Wicker introduced the LOCAL Infrastructure Act, which would restore the ability of state and local governments to use tax-exempt advance refunding, limited to one advance refunding per bond issue.4U.S. Senate. Bennet, Wicker Introduce Bipartisan Legislation to Reinstate Advance Refunding for State and Local Infrastructure Projects Similar bills have failed in prior sessions, so issuers planning debt strategy should not count on restoration.
The Alternatives Municipal Issuers Use Now
With tax-exempt advance refunding off the table, municipal issuers have turned to several workarounds. Each has trade-offs.
Taxable Advance Refunding
The simplest alternative is to issue taxable bonds to advance refund tax-exempt debt. The Section 149(d) prohibition applies only to tax-exempt bonds, so taxable advance refunding bonds remain available.3Internal Revenue Service. Advance Refunding Bond Limitations Under Internal Revenue Code Section 149(d) Because investors pay federal income tax on the interest, they demand a higher coupon, which eats into the savings that motivated the deal. This structure only pencils out when the rate gap between the old bonds and current taxable rates is wide enough to overcome the tax-exemption premium.
Forward Delivery Bonds
A forward delivery bond is priced today but doesn’t settle until a specified future date, typically within 90 days of the old bonds’ call date so the transaction qualifies as a current refunding. The issuer locks in today’s rates without triggering the advance refunding prohibition. Investors charge a premium for committing capital they can’t redeploy during the forward period, and the contracts need extra documentation and contingency provisions. Issuers using this route generally need strong credit ratings, often at least AA.
Crossover Refunding
In a crossover refunding, the issuer sells new bonds and invests the proceeds, but the old bonds are not defeased. Until the call date, known as the crossover date, the issuer keeps paying debt service on the old bonds from its own revenue while investment earnings on the escrowed new-bond proceeds pay interest on the new bonds. On the crossover date, the escrow pays off the old bonds, and the issuer’s revenue stream shifts to servicing the new bonds.5Internal Revenue Service. TEB Phase III – Lesson 1, Refundings Because the old bonds stay undefeased until the crossover date, the legal and accounting treatment differs from a traditional advance refunding with escrow defeasance.
Escrow and Defeasance
When an issuer can’t retire the old bonds immediately, the new bond proceeds go into an irrevocable escrow account. That escrow is invested in U.S. government securities structured to mature on the dates the old bonds’ interest and principal come due, ending on the call date when the remaining old bonds are redeemed.
This arrangement produces what’s called defeasance, and the two versions matter. In a legal defeasance, the bond trustee or creditor formally releases the issuer from its obligation on the old bonds, and the debt is legally extinguished. Whether this is available depends on the terms of the original bond indenture; not every agreement 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 formally release the issuer. The debt is economically neutralized, yet the issuer remains technically on the hook if the escrow somehow falls short. The distinction has real consequences for financial reporting.
Arbitrage Rules and the Rebate Requirement
Federal tax law blocks issuers from profiting on the spread between their low tax-exempt borrowing rate and higher-yielding investments. Under 26 U.S.C. § 148, a bond qualifies as an “arbitrage bond” if its proceeds are expected to be invested in securities that yield materially more than the bond itself yields.6Office of the Law Revision Counsel. 26 USC 148 – Arbitrage Any bond classified as an arbitrage bond loses its tax-exempt status entirely 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 matters in refundings because the escrow is exactly the kind of investment the rules target. Escrow securities must be structured to avoid yielding more than the bond issue’s own yield. Narrow exceptions apply 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 an issuer that complies with yield restrictions must calculate and return any excess arbitrage earnings to the Treasury. Rebate payments are due in installments at least every five years, each covering at least 90% of the cumulative excess earnings as of that date, and a final payment is due 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 a rebate file IRS Form 8038-T with the payment. Missing those deadlines can trigger late interest and, in serious cases, retroactive reclassification of the bonds as taxable.
What Refunding Means for Bondholders
Refunding is an issuer-side strategy, but bondholders feel the consequences. The biggest is reinvestment risk. When bonds are called early, investors get their principal back ahead of schedule and must reinvest at whatever rates the market offers. Because refundings generally follow a drop in rates, bondholders usually reinvest at lower yields, which is precisely why the issuer found the deal worthwhile.
Bondholders do receive the call premium set in the original indenture, which partially compensates for the early redemption. Optional call provisions commonly let the issuer redeem on or after a date that is usually about 10 years after issuance.1Municipal Securities Rulemaking Board. Refundings and Redemption Provisions Some bonds carry make-whole call provisions, which pay investors a lump sum calculated on a net present value basis to offset lost interest.
Once bonds have been advance refunded and are backed by an escrow of Treasuries, the credit risk changes. The bondholder is no longer relying on the issuer’s ability to pay; the escrow provides the security. The MSRB notes that investors should check whether any of the escrow securities themselves are callable, since that would introduce reinvestment risk inside the escrow.1Municipal Securities Rulemaking Board. Refundings and Redemption Provisions In a partially refunded issue, only the refunded portion is backed by the escrow, and investors should confirm that refunded bonds carry a separate CUSIP number.
Accounting Treatment
How a refunding shows up on the issuer’s financial statements depends on the type of issuer.
State and local governments follow Governmental Accounting Standards Board rules. Under GASB Statement No. 23, the difference between the amount paid to retire the old bonds (the reacquisition price, including any call premium) and the book value of those bonds is not recognized immediately. The difference 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.
Corporations follow FASB rules. A gain or loss on debt extinguishment through refunding is recognized in the current period’s income statement as part of ordinary income, since the “extraordinary item” classification was eliminated for fiscal years beginning after December 15, 2015. Companies often disclose the gain or loss as a separate line so investors can see the impact.
Treatment of in-substance defeasance also differs between the two frameworks. Under FASB, placing assets in an irrevocable trust to service the old debt does not by itself let the issuer remove the debt from the balance sheet; the liability stays until the creditor formally releases the issuer in a legal defeasance. Governmental standards are more permissive, which is one reason the escrow-and-defease model has been so central to municipal finance.