Municipal Bonds are generally seen as safe investments since they are often backed by a series of cash flows or taxing powers of the issuer. Many investors prefer to invest in bonds as they can be a safe alternative to owning stocks.
Pre-refunded Municipal Bonds
There are, however, some measures that issuers can take to make their debt even safer, including pre-refunding. Pre-refunding can be a good choice for conservative investors, especially with callable bonds. Callable bonds usually have a lower yield, unlike noncallable bonds, which typically have a higher yield but carry more risk.
A pre-refunded municipal bond is a bond that the issuer decided to redeem from the bondholder before its maturity date. Only callable bonds can be considered for early redemption at a lower interest rate, provided that the terms stated in the bond prospectus allow it. Non-callable bonds that are redeemed at an early date pay the full interest amount.
Some issuers choose to call their issued bonds in order to avoid paying high interest expenses; this results in most calls occurring during a time when interest rates are low. New bonds are then given to the bondholders at lower rates, cancelling out the previous bonds. After the issuer distributes the new bonds, it will then often purchase Treasury securities that mature around the same time as the original bonds. The interest accumulated from the Treasury securities pays off the interest from the pre-refunded bond. Since pre-refunded bonds are a safe investment, they are very appealing to some conservative investors; however, these bonds do have very low yields.
If a bond is not callable, the issuer is not required to pay the full interest amount to the bondholder. However, the bondholder receives the originally expected interest payment from the U.S. Treasury.
Investing in Pre-refunded Municipal Bonds
In addition to owning individual bonds, there is also the option of owning a municipal bond ETF that offers a bundle of pre-refunding bonds.
The Pre-Refunded Municipal Index ETF (PRB) allows investors to invest strictly in pre-refunded securities. This ETF corresponds with the price and yield performance of the Barclays Capital Municipal Pre-Refunded Treasury-Escrowed Index (LMPETR). The index is made up of pre-refunded and escrowed to maturity securities.
The Bottom Line
Pre-refunded municipal bonds may be a good option for some investors wary of the risk of bonds. Most bonds are rated AAA since they are backed up by the U.S. Treasury. These bonds also are very beneficial to the issuer, giving them more control over their expenses.