James Volley, CFA, is evaluating a number of municipal bonds. One of the revenue bonds on his list is marked as "prercfunded." When Volley asks his assistant about the bonds, the assistant tells him that the collateral behind the bonds is a portfolio of U.S. government securities, and that, therefore, these bonds have "less credit risk than insured municipal bonds." Which of the following statements regarding these bonds is most accurate"?
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A. B. C.Explanation
The most accurate statement regarding the "prerefunded" bonds in this scenario is option C: Prerefunded bonds are secured by a cash escrow account, not by US government securities.
The assistant's statement to James Volley, CFA, that the collateral behind the bonds is a portfolio of U.S. government securities and that these bonds have less credit risk than insured municipal bonds is incorrect. This suggests a misunderstanding or confusion on the part of the assistant.
In reality, "prerefunded" bonds are a type of municipal bond that has been refunded or paid off before its maturity date. This means that the issuer has set aside funds in a cash escrow account, which will be used to make future interest and principal payments to bondholders. The cash in the escrow account is typically invested in U.S. government securities, such as Treasury bonds or Treasury bills, to generate income and ensure the availability of funds for the bond payments.
The purpose of refunding a bond is often to take advantage of lower interest rates or other favorable market conditions. By prerefunding the bond, the issuer can retire the existing bond and replace it with a new bond issue at a lower interest rate, thereby reducing their borrowing costs.
Prerefunded bonds are generally considered to have lower credit risk than regular municipal bonds because the cash in the escrow account is held separately and can be used solely for bond payments. This provides an additional layer of security for bondholders. However, it's important to note that the credit risk of prerefunded bonds ultimately depends on the creditworthiness of the issuer, as they are still responsible for making the payments from the escrow account.
In summary, the accurate statement regarding these bonds is that prerefunded bonds are secured by a cash escrow account, not by U.S. government securities. The assistant's claim about the collateral being U.S. government securities and the comparison to insured municipal bonds is incorrect.