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Advance refunding is the early refinancing of municipal securities. A new issue of bonds is sold to retire an outstanding bond issue at its first available call date or upon maturity. The proceeds of the new issue are held in escrow and are used to retire the original issue.
Often times states and local municipalities will want to take advantage of a low interest rate environment and will issue bonds to lock in the low rate for an extended period of time. When states and local municipalities issue bonds in anticipation of retiring existing bonds the process is known as advance refunding. Once the new bonds have been issued and the proceeds placed in escrow, the original bond issue becomes prerefunded. The outstanding bonds are now backed by cash or special government securities known as SLUGS, which are held in escrow until the first call date or until maturity. The original issue is now considered to be rated AAA and may be removed from the issuer’s debt statement.