Let's say you want to buy a shiny, used Bugatti on credit. The debt service costs a cool $3,000 per month—how can you make sure you can make the payments? Well, you might want to sock away a bunch of Gs in the bank.
Advance prefunding works the same way—but with bonds, not cars. With "safe" bonds, or bonds where an administrator is worried about the cash actually getting to the people for whom it was intended, a prefunding feature can ensure that money is socked away.
When a bond is issued, a chunk of money is tucked away safely in a nice escrow account with a bank or trust company so that the odds of the money actually being there for a distribution or a call provision are high. It's extra netting under the financial high wire.
What happens if a government issues bonds and then runs a little short when it's time to pay up? One option is to issue a new bond to pay off the outstanding bond (that means a past due bond—not great). That's called advance refunding, and it buys the issuer a little extra time in paying off their debt.
P.S. The concept is kind of arcane.
Related or Semi-related Video
Finance: What is the Times Covered Inter...23 Views
finance a la shmoop- what is the times covered interest ratio?
okay people. we'll just restate the question if it's simpler. from your [girl frowns in classroom]
operating profits this part of your income statement right here- how many
times is your interest expense covered? still not simple enough? okay how about
this? how big a multiple is your operating
profit of your interest cost? there we set it boom. okay so you run furry nation [definitions listed]
America's finest purveyor of animal bodysuits. the company has two billion
dollars in debt on which you pay six percent interest or 120 million dollars
a year. you really wanted that platinum encrusted fidgets spinner and well you
just couldn't wait. furry nation has revenues of three billion dollars and [hand spins fidget spinner]
conveniently has operating profits of 360 million. so how many times larger is
your operating profit than your yearly interest? well check out the hundred
twenty million dollars error of interest from before, that number gets divided
into the operating profit number. and the answer? three. well why does this ratio [equations]
matter? well the three times interest covered number is a solid indication of
how easily you can pay the interest if not the principle of the debt you have
borrowed. think about a normal boom and bust business cycle. in a bad year your [bridge blows up]
company might shrink to have only two billion of revenues and 180 million
dollars of operating profits. in which case in that dismal year it would have
only one point five times interest coverage. in a great year with say 900
million of operating profit while the coverage ratio would be 6x or 600 [equations]
percent or six times. now put your butt in the seat of the lender. if you're the
one who loaned the two billion dollars at 6% while you're getting pretty
nervous about being able to collect your money back when operating profits are
down to just one point five times. but it's six times interest well you sleep [woman snores in bed]
like a baby happy to keep collecting your interest payment though. so why do
we use operating profits this line here instead of net income or after-tax
profits this line here when we calculate the times interest ratio? well because
interest costs are tax-deductible? they're a cost just like [definitions]
plastic or office building rent or mandatory company yoga retreats. the cost
of renting money is treated for tax purposes really no different from the
cost of renting a building. so we don't worry about taxes when we're focused on
just repaying our debts. just don't try to use that excuse when tax time comes [woman smiles behind desk]
around though. Uncle Sam well he don't play.
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