Commonly, crossover refunding is utilized by local governments when they issue new municipal bonds (called pre-refunding bonds) whose proceeds are placed in escrow and used to make debt service payments on the refunding bonds until the call date of the original, higher interest rate, municipal bonds. At that point, the refunding bond proceeds crossover and are used to pay the principal and the call premium and extinguish the original bond, which is commonly called the refunded bond.
When prevailing interest rates in the economy decline, there is an opportunity for municipal bond issuers to refinance or refund their outstanding bonds at the lower rate. A municipality might also decide to refund its bonds in order to get better debt covenants or to obtain a better debt service schedule. To achieve this, the issuer will redeem the bonds prior to their maturity by paying the principal investment and any accrued interest to bondholders. However, the call protection provision for callable bonds prevents borrowers from retiring high coupon paying bonds until the call date specified on the bond indenture. During this lockout period, the borrowing municipality can issue new bonds (referred to as refunding bonds) at lower interest rates.
Proceeds from the bond are deposited in an escrow account. The investment interest earned in the escrow account is used to service the refunding bond until the call date of the outstanding bond. On the call date, the funds in the escrow account crossover to refund or retire the outstanding bonds by paying the interest and principal amounts on the debt. During the lockout period, the existing bonds (or refunded bonds) continue to be serviced with the revenue stream originally pledged to secure them. After the refunded bonds have been paid off with the funds held in escrow, the refunding bonds become payable from the original pledged revenue stream. Hence, the term “crossover refunding”.
In effect, crossover refunding refers to a method of refunding in which the lien securing the outstanding bond crosses over to secure debt payments on the refunding bond, and the escrowed funds which were initially used to cover payments on the refunding bond crossover to pay off bondholders of the outstanding bond. Crossover refunding differs from a traditional refunding process in that the proceeds of the refunding bond issue are deposited in the escrow account and held there until the call date of the existing issue, at which point any securities in the escrow account are sold to redeem the outstanding bond.
When 90 days or fewer are left in the original bonds’ terms, the refunding is called “current”. When more than 90 days remain, the refunding is called “advance”. Alternatives to a crossover refunding include net cash refunding, which is more common, and full cash or gross refunding, which is less common.