refunding and municipal bonds/tax exempt bonds

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One important question in reviewing the terms of a new municipal bond issue is whether the issuer has the right to "call" or "refund" the bonds prior to maturity, either in whole or in part. A call of a bond issue is the early retirement of part of an outstanding bond issue. A refunding is the issuance of new bonds (the "refunding bonds") to retire the entirety of a prior issue (the "refunded bonds"). The refunded bonds originally may have been issued as general obligation or revenue bonds. Refunding bonds are issued to pay off the old bonds, which are then secured by an "escrow fund" consisting of investments that are sufficient for paying the bondholders. This fund will have a maturity schedule which matches payments due on the refunded (original) bond issue.
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<br>Most municipal securities are issued with a call provision listed in the bond issue's Official Statement which describes the terms and conditions under which an issuer may redeem bonds. In most cases, issuers may not change call provisions once the original bonds have been issued. The call privilege is the right by the issuing entity to repurchase the refunded bonds at a fixed price. Whether a bond is callable immediately after it is issued or after a deferred period, the bonds' redemption price usually includes a premium over par value (face value). The "call premium" is usually 1 to 3 percent above par scaling down to par value as the bond approaches maturity. Since the call premium usually declines over time, (making it cheaper for the issuer to call) the likelihood of a call will be higher in the later years than in earlier years. This is also true because the coupon interest rate on the bonds is usually higher on the longer bond maturities, as investors are usually compensated for investing for longer periods. The higher the coupon interest rate, the more the issuer has an incentive to refinance. The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible date or a subsequent call date established in the original bond indenture. It is common to preclude a call for the earliest part of the bond ...