A current refunding bond allows the issuer to refinance within 90 days of a call date. If interest rates have fallen, the issuer will want to refinance. Suppose, however, interest rates have dropped significantly, and the next call date is not on the near horizon. An advance refunding bond allows the issuer to lock in the lower interest rates now without risking that they rise before the call date arrives and make the refunding less attractive. For the investor, the risk is similar to a callable bond, except that once an advance refunding has occurred, the refunded bond has a reduced default risk (increasing its credit rating) and a set termination date, which combine to increase its value.
Since 1986, advance refunding has only been permitted for government bonds and “qualified” private activity bonds, PABs that have a public purpose. However, with the passage of the Tax Cuts and Jobs Act of 2017, any advance refunding bond issued after December 31, 2017, loses its tax-exempt status. In addition, since 2018, newly issued advance refunded municipal bonds will be required to pay federal tax on their interest income.
