Crossover Refunding: Definition, Examples, and Benefits
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Summary:
Crossover refunding is a financial strategy used by local governments to lower their borrowing costs by issuing new bonds, whose proceeds are used to redeem higher-interest bonds. This process involves placing the new bond proceeds in an escrow account to make debt service payments until the call date of the original bonds. Once the call date arrives, the escrowed funds are used to pay off the original bonds, effectively “crossing over” to the new bonds. This article explores how crossover refunding works, its benefits, and alternatives.
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Introduction to crossover refunding
Crossover refunding is a financial strategy used by local governments to lower their borrowing costs by issuing new bonds, whose proceeds are used to redeem higher-interest bonds. This process involves placing the new bond proceeds in an escrow account to make debt service payments until the call date of the original bonds. Once the call date arrives, the escrowed funds are used to pay off the original bonds, effectively “crossing over” to the new bonds.
Understanding crossover refunding
How crossover refunding works
Crossover refunding typically involves local governments issuing new municipal bonds, known as pre-refunding bonds. The proceeds from these pre-refunding bonds are placed in an escrow account and used to make debt service payments on the higher-interest rate bonds until their call date.
Advantages of crossover refunding
One of the primary advantages of crossover refunding is the potential for significant interest cost savings for the issuer. By refinancing higher-interest rate bonds with lower-interest rate bonds, governments can reduce their borrowing costs and free up funds for other purposes.
Additionally, crossover refunding can allow governments to improve their debt covenants or obtain a more favorable debt service schedule. This can lead to increased financial flexibility and stability for the issuer.
Alternatives to crossover refunding
While crossover refunding can be an effective strategy for lowering borrowing costs, there are alternatives that governments may consider. One common alternative is net cash refunding, which involves using available cash to retire outstanding bonds.
Another alternative is full cash or gross refunding, which involves issuing new bonds and using the proceeds to retire outstanding bonds without placing them in escrow. However, this approach is less common due to the need for sufficient cash flow to cover debt service payments.
Key considerations
Timing
It’s important for governments to carefully consider the timing of crossover refunding. Refunding can be classified as “current” when there are 90 days or fewer left in the original bonds’ terms, or “advance” when more than 90 days remain. Understanding these timing considerations can help governments make informed decisions about when to pursue crossover refunding.
Risk factors
While crossover refunding can offer significant benefits, it’s not without risks. Governments must consider factors such as interest rate fluctuations, market conditions, and credit ratings when evaluating the feasibility of crossover refunding. Additionally, there may be costs associated with issuing new bonds and establishing escrow accounts, which can impact the overall cost savings of the strategy.
Examples of crossover refunding
Municipal bond issuance
A city government issues municipal bonds to fund a major infrastructure project. However, after a few years, interest rates decline significantly. To take advantage of lower rates, the city decides to engage in crossover refunding. It issues new bonds at the lower interest rate and uses the proceeds to redeem the original bonds, thereby reducing its borrowing costs and freeing up funds for future projects.
Corporate bond refinancing
A corporation issues corporate bonds to raise capital for expansion. Several years later, interest rates fall, presenting an opportunity for the company to lower its borrowing costs. The company engages in crossover refunding by issuing new bonds at the lower rate and using the proceeds to retire the original bonds. This allows the company to improve its financial position and potentially increase shareholder value.
Subheadings for evaluating crossover refunding
Financial analysis
Before pursuing crossover refunding, governments and corporations must conduct a thorough financial analysis to assess the potential benefits and risks. This analysis may include evaluating current interest rates, projecting future cash flows, and considering alternative financing options.
Legal considerations
Crossover refunding involves complex legal considerations, including compliance with bond indentures, tax regulations, and securities laws. Governments and corporations must work closely with legal advisors to ensure that the refunding process is executed properly and in accordance with applicable laws and regulations.
Benefits of crossover refunding
Debt service reduction
By refinancing higher-interest rate bonds with lower-interest rate bonds, governments and corporations can achieve significant reductions in debt service costs. This can lead to savings in interest expenses over the life of the bonds, allowing entities to allocate resources to other priorities or projects.
Improved cash flow
Crossover refunding can improve cash flow by lowering debt service payments. With lower interest expenses, governments and corporations may have more funds available for operations, capital investments, or debt reduction. Improved cash flow can enhance financial stability and flexibility, enabling entities to better manage economic uncertainties or unexpected expenses.
Challenges of crossover refunding
Market timing risks
Timing is crucial in crossover refunding, as it involves predicting interest rate movements and market conditions. If interest rates rise after issuing new bonds but before redeeming the original bonds, the expected cost savings may not materialize. Governments and corporations must carefully assess market conditions and risks before engaging in crossover refunding.
Costs and administrative burdens
Crossover refunding involves various costs and administrative burdens, including underwriting fees, legal expenses, and administrative costs associated with establishing and maintaining escrow accounts. These costs can reduce the overall savings achieved through refunding and may impact the decision-making process for governments and corporations.
Evaluating crossover refunding: financial analysis
Interest rate analysis
A critical component of financial analysis for crossover refunding is assessing current and projected interest rates. Entities must analyze market trends, yield curves, and economic indicators to determine the optimal timing for issuing new bonds and redeeming original bonds.
Cash flow projections
Cash flow projections are essential for evaluating the feasibility of crossover refunding. Entities must estimate future debt service payments, including interest and principal payments, under different scenarios. Cash flow analysis can help entities assess the impact of refunding on their financial position and determine the potential savings generated.
Conclusion
Crossover refunding is a financial strategy that can help local governments lower their borrowing costs and improve their financial flexibility. By issuing new bonds and using the proceeds to redeem higher-interest rate bonds, governments can achieve significant interest cost savings over time. However, it’s important for governments to carefully evaluate the timing and risks associated with crossover refunding to ensure it aligns with their financial goals and objectives.
Frequently asked questions
What is the difference between current and advance crossover refunding?
Crossover refunding can be classified as “current” when there are 90 days or fewer left in the original bonds’ terms, or “advance” when more than 90 days remain. The classification depends on the remaining time until the call date of the original bonds.
How do governments and corporations benefit from crossover refunding?
Governments and corporations benefit from crossover refunding by lowering their borrowing costs. By refinancing higher-interest rate bonds with lower-interest rate bonds, entities can achieve significant interest cost savings over time, leading to improved financial flexibility and stability.
What are the alternatives to crossover refunding?
Alternatives to crossover refunding include net cash refunding and full cash or gross refunding. Net cash refunding involves using available cash to retire outstanding bonds, while full cash or gross refunding involves issuing new bonds and using the proceeds to retire outstanding bonds without placing them in escrow.
What are the key considerations for evaluating crossover refunding?
Key considerations for evaluating crossover refunding include timing and risk factors. Governments and corporations must carefully assess market conditions, interest rate fluctuations, and credit ratings to determine the optimal timing for pursuing refunding and mitigate potential risks associated with the strategy.
What legal considerations are involved in crossover refunding?
Crossover refunding involves complex legal considerations, including compliance with bond indentures, tax regulations, and securities laws. Governments and corporations must work closely with legal advisors to ensure that the refunding process is executed properly and in accordance with applicable laws and regulations.
How can entities conduct financial analysis for crossover refunding?
Entities can conduct financial analysis for crossover refunding by assessing current and projected interest rates, analyzing market trends, yield curves, and economic indicators. Cash flow projections are essential for evaluating the feasibility of refunding and determining the potential savings generated.
What are the risks associated with crossover refunding?
While crossover refunding offers benefits such as debt service reduction and improved cash flow, it also poses risks. Risks include interest rate fluctuations, market timing risks, and administrative burdens. Additionally, there may be costs associated with issuing new bonds and establishing escrow accounts, impacting the overall cost savings of the strategy.
Key takeaways
- Crossover refunding involves issuing new bonds to redeem higher-interest rate bonds.
- The proceeds from the new bonds are placed in an escrow account until the call date of the original bonds.
- Timing and risk factors should be carefully considered when evaluating crossover refunding as a financial strategy.
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