An escrow is a legal arrangement where money is held by a third party until certain conditions are met. Escrows are often used for refunded bonds to hold the bond proceeds.
In the case of refunded bonds…
Bond refunding is a practice that government entities can use to pay off more expensive bonds with lower-interest debt.
In other words, it’s a way of refinancing a bond issuer’s outstanding debt to make it more affordable. When a bond issuer does this, they hold the proceeds from the new bonds in an escrow account, which can consist of cash and securities whose cash flow is exactly enough to meet the debt service payments due on the refunded bonds.
The escrow account can be active for anywhere from one day to 30 years, depending on the maturity of the bonds being refunded.
Suppose a municipality issued bonds at a rate of 10%. In the time since the bond issue, market interest rates have decreased, and the municipality’s credit rating has improved, meaning it can issue bonds at a considerably lower coupon now.
Because the high-interest bonds are callable, the municipality can pay them off early with the money gained from lower-rate bonds. So, the municipality issues new bonds at a lower interest rate and places the proceeds in an escrow account where it invests them in low-risk securities like state and local bonds and Treasury securities until the money is needed to redeem the high-interest bonds.
What’s important here?
As we mentioned, an escrow can hold both cash and securities purchased with a bond’s proceeds. However, there are limits on the types of securities that can be purchased. These securities, known as allowable investments, include state and local government series securities (SLGS), Treasury securities, some federal agency securities, and some tax-exempt securities.
The escrow is restricted in its ability to be invested by its defined permissible reinvestment earnings rate, which is either the rate currently achievable on the open market or the arbitrage yield of the refunding bonds issue, depending on the type of refunding.