State and Local Governments

Use of the Proceeds: New-Issue vs. Refunding Bonds

Long-term tax-exempt bond issues also can be characterized by their status as new issues or refunding issues (refundings). New issues represent bonds issued to finance new capital facilities. Refundings usually are made to replace outstanding bonds with bonds that carry lower interest rates or other favorable terms. As such, the refunding bonds usually do not add to the stock of outstanding bonds or the capital stock. The proceeds of the refunding bonds are used to pay off the remaining principal of the original bond issue, which is retired. Advance refunding bonds, however, do add to the outstanding stock of bonds without adding to the stock of capital. Advance refunding bonds are issued prior to the date on which the original bonds are refunded, so that for a period of time there are two bond issues outstanding to finance the same capital facilities. The 2017 tax revision repealed the exclusion of interest income on advance refunding bonds issued after December 31, 2017.

Figure 3 shows the changes in new-issue and refunding municipal bonds from 1992 through 2016. The volume of refunding shares varies widely, depending to a great extent on changes in the relative magnitudes of taxable and tax-exempt interest rates. Note that the 1993 increase in the top marginal individual income tax rates may have increased the demand for tax-exempt bonds (see Figure 2). Higher tax rates make tax-exempt bonds more attractive relative to taxable bonds, all other things being equal. The increased demand and accompanying lower interest rates may have prompted state and local governments to replace outstanding issues with refunding bonds that carried lower interest rates. In contrast, refundings dropped considerably in 1999 and 2000. The decline could have been in response to higher interest rates or to strong economic conditions in most states which minimized the need for debt finance generally. The story is reversed from 2001 to 2003 as the economy slowed and state budgets were strained by lower tax revenue collections. Refundings issues in 2003 were more than double the amount of new issues in 2000. In 2005, GO bonds and refunding bond volume peaked, likely reflecting the historically low interest rates on tax-exempt debt. The low rate environment since 2011 has also pushed up the share of refunding issues.

Figure 3. Volume of Long-Term Tax-Exempt Debt: New-Issue and Refunding Bonds, 1992 to 2016