Besides reducing its interest costs, what other general reason does the MSRB give for an issuer to refund its outstanding bonds?

To lengthen the call protection on the bonds being refinanced, so that their holders keep the higher coupon for longer

To remove a burdensome or restrictive covenant that the terms of the bonds being refinanced impose on the issuer

To move the debt off the issuer's books permanently, the refunding bonds being owed by the escrow agent rather than the issuer

To reset the credit rating on the bonds being refinanced, a refunding requiring the agencies to withdraw the rating they assigned

A financial adviser reports to a city council the present value savings of a proposed refunding. How are present value savings arrived at?

By adding the refunding issue's costs of issuance to the escrow deposit and comparing that total with the par amount refunded

By totalling the undiscounted debt service on the refunding issue and subtracting it from the refunded issue's outstanding par

By discounting at a chosen rate the difference between future debt service on the refunded issue and on the refunding issue

By comparing the yield on the escrow investments with the yield on the refunding bonds over the whole life of the escrow

Refunding bonds are issued on 10 January. On 1 February part of their proceeds pays an interest instalment on the prior issue, and on 1 June, 142 days after the issue date, the rest redeems the prior issue. How do the regulations at 26 CFR 1.150-1(d) treat the refunding issue?

As falling outside the current refunding window, the count running to the 1 June redemption, the last use of proceeds on the prior issue

As falling inside the current refunding window, the count running to the 1 February payment, the first use of proceeds on the prior issue

As falling inside the current refunding window, payments of interest made from the proceeds being disregarded in measuring the period

As falling outside the refunding rules altogether, an issue whose proceeds pay interest on another issue not being a refunding issue

An escrow funded with refunding bond proceeds will pay off the refunded bonds 60 days after the refunding bonds are issued. The refunded bonds' resolution requires an accountant's verification before any advance refunding of them. How should the transaction be classified?

Its classification can be only one, since state law and bond contracts adopt the federal tax definition

Its tax and contract classifications can differ, the federal tax line not governing how the bond resolution uses the term

Its classification can be read from the escrow, any refunding with an escrow being the same kind for tax and contract alike

Its classification can be read from the call date, a refunding to a call date counting as current under the resolution too

A nonprofit hospital buys the facilities of an unrelated hospital and, as part of the purchase, assumes that hospital's outstanding bonds. Four months later it refinances the assumed bonds with a new issue. How do the regulations treat the new issue?

It is treated as a refunding issue only if the holders of the assumed bonds have consented in writing to the assumption itself

It is treated as a refunding issue, because its proceeds pay principal on an issue that the buying hospital is now obliged to pay

It is not treated as a refunding issue, the refinancing coming within six months of an assumption made in an asset acquisition

It is not treated as a refunding issue, a refinancing of assumed obligations being excluded however long after the assumption

Issue A was issued by a county. Proceeds of Issue B are used to pay principal on Issue A, but Issue B's obligor is a water company that is neither the county nor a related party of the county. Is Issue B a refunding of Issue A?

No, since a refunding needs the new issue to be sold by the underwriter that sold the prior issue

Yes, since an issue whose proceeds pay principal on another issue refunds it whoever the obligors are

Yes, but only once Issue A has been legally defeased under the procedure its own bond contract sets

No, where Issue B's obligor is neither Issue A's obligor nor a party related to that obligor

Section 13532 of Public Law 115-97 rewrote section 149(d)(1) of the Internal Revenue Code. How did the rewrite change which advance refunding bonds are denied tax exemption?

A denial once confined to bonds in issues described in listed paragraphs came to reach any bond issued to advance refund another

A denial once reaching every advance refunding bond came to be confined to private activity bonds and to abusive transactions

A denial once confined to advance refunding bonds came to reach the bonds of current refundings made within the window as well

A denial once reaching governmental bonds alone came to reach private activity bonds, leaving governmental refundings exempt

Which of these is an eligible source of funds with which an issuer may buy State and Local Government Series securities?

Proceeds of a taxable bond issue sold to refund an earlier taxable issue, with no tax-advantaged bonds involved at any stage

Proceeds of a taxable bond issue that is sold to advance refund an outstanding issue of the issuer's tax-exempt bonds

Proceeds of a corporate bond issue sold by a private company to refund its own outstanding taxable debentures

Cash in a city's general fund held for payroll, kept apart from any bond proceeds and from any refunding escrow

An issuer cannot advance refund an outstanding issue but wants to fix the terms of its refinancing now. Under a forward refunding, what does it agree to?

To have its old bonds remarketed on a future date at a new rate that the underwriter of those old bonds sets on that date

To deposit cash now with an escrow agent, which invests it until the old bonds' call date and then uses it to redeem them

To buy back the old bonds now through a tender offer financed by a bank loan, repaid once new bonds are sold at the call date

To issue bonds on a specified future date to an underwriter that agrees now to buy them, their proceeds then refunding the old bonds

In a synthetic refunding, how does an issuer realize now the debt service savings it would have had from advance refunding its bonds?

It receives an upfront payment from a counterparty in return for an action or right that can be exercised on a future call date

It pays an upfront fee to a counterparty that agrees to redeem the outstanding bonds at once at the price set for their first call

It deposits its own reserve funds in an escrow that is invested in SLGS until the outstanding bonds can be called and redeemed

It issues new bonds now and lends their proceeds to a counterparty, which repays the loan on the outstanding bonds' call date

In a crossover refunding, how is debt service paid during the period when both the refunded bonds and the refunding bonds are outstanding?

The refunded bonds from the escrowed proceeds, and the refunding bonds from the revenues first pledged to the refunded bonds

The refunded bonds from their originally pledged revenues, and the refunding bonds from interest earned on the escrowed proceeds

Both issues from the escrowed proceeds, the pledged revenues being released to the issuer until the refunded bonds are called

Both issues from the originally pledged revenues, the escrowed proceeds being held untouched until the refunding bonds mature

In a refunding, what does the verification report prepared by a certified public accountant or other independent party establish?

That the issuer's pledged revenues will cover debt service on the refunding bonds at the ratio the indenture sets

That the refunding bonds are validly issued and that their interest is excluded from the holders' gross income

That the escrowed investments have the stated yield and produce cash flow sufficient to pay the refunded bonds

That the refunding produces present value savings above the minimum set by the issuer's own debt policy

An escrow is sized as a net cash refunding. What must produce the money needed to pay debt service on the refunded bonds?

The principal of the escrowed securities, with their interest kept by the escrow agent to meet its own fees

The refunding bond proceeds, with any interest earned on them paid over to the issuer's general fund as it accrues

The issuer's annual appropriations, the escrow being kept as a reserve in case an appropriation is missed in some year

On the day a subscriber starts a SLGS subscription, the current Treasury borrowing rate for the chosen maturity is 3.47 percent. What is the highest rate the issuer may designate for that Time Deposit security?

3.46 percent, the current Treasury borrowing rate less one basis point

3.47 percent, the current Treasury borrowing rate with no adjustment

3.48 percent, the current Treasury borrowing rate plus one basis point

3.37 percent, the current Treasury borrowing rate less ten basis points

An issuer subscribes for SLGS to fund an escrow, with an issue date three weeks away. Rates then move so that open-market Treasury securities would now fund the escrow more cheaply. May the issuer cancel the SLGS subscription?

Yes, provided it gives Treasury notice at least seven days before the issue date set in its subscription

Not on that ground, since a cancellation needs a reason unrelated to using SLGS to create a cost-free option

Yes, provided it pays Treasury a market charge equal to the change in value since the subscription began

Not at all, since a subscription becomes irrevocable as soon as the day's SLGS rate table has been applied

An issuer redeems before maturity a SLGS note it subscribed for in 2015. The note's stated rate is 4.2 percent, and the current Treasury borrowing rate for its remaining term is 3.1 percent. What does the issuer receive, apart from interest for the broken period?

Less than the principal, a market charge being deducted for redeeming a note before its scheduled maturity

The principal exactly, SLGS notes being redeemed early at their face amount whatever has happened to rates

More than the principal, the remaining payments being discounted at the lower current Treasury borrowing rate

Less than the principal, the remaining payments being discounted at the note's own higher stated rate of interest

For the arbitrage yield rules, what is the fair market value of a SLGS security in an escrow on a date after its purchase date?

The price of a marketable Treasury of the same maturity

Its purchase price, carried unchanged until it matures

Its par amount plus the interest accrued up to that date

Its redemption price for a redemption made on that date

An issuer buys open-market securities for a yield restricted defeasance escrow through competitive bidding and wants the fair market value safe harbor. Which comparison with SLGS must the winning bid satisfy?

Its cost, broker's fees included, must be no greater than that of the most efficient all-SLGS portfolio

Its yield, broker's fees left out, must exceed by one basis point the yield of a matching SLGS portfolio

Its cost must be at least that of a SLGS portfolio, so that the escrow can earn no less than SLGS would

Its securities must mature on the same dates as those in a SLGS portfolio subscribed for on that same day

An issuer invests a construction fund and a refunding escrow, both funded from tax-exempt bonds. How do the arbitrage regulations define a materially higher yield for the investments in each?

One-thousandth of a point for the construction fund, and one-eighth of a point for the refunding escrow

One-eighth of a point for the construction fund, and one-thousandth of a point for the refunding escrow

One-eighth of a point for both, the regulations using one definition for every nonpurpose investment

One and one-half points for the construction fund, and one-eighth of a point for the refunding escrow

A prior issue has 40 million dollars of principal outstanding and 2 million dollars of unspent proceeds. Proceeds of a refunding issue discharge 10 million dollars of that principal. How much of the prior issue's proceeds become transferred proceeds of the refunding issue?

Nothing, the unspent proceeds staying with the prior issue until the whole of its principal has been discharged

2 million dollars, all of the prior issue's unspent proceeds moving once any of its principal has been discharged

500,000 dollars, the unspent proceeds multiplied by the principal discharged over the principal outstanding before it

666,667 dollars, the unspent proceeds multiplied by the principal discharged over the principal left afterwards

Proceeds of a prior issue are within a three-year temporary period for a capital project when, in 2016, the issuer advance refunds that issue with tax-exempt bonds. What happens to that temporary period?

It ends on the date on which the refunded bonds are redeemed, wherever that falls within the original period

It runs on to its original end, the refunding having no effect on the prior issue's own temporary periods

It restarts on the issue date of the refunding issue, giving the transferred proceeds a new three-year period

It ends on the issue date of the advance refunding issue, for amounts that become transferred proceeds as well

How does section 148(f) of the Internal Revenue Code schedule an issuer's payments of arbitrage rebate on an issue?

Installments at least once every five years, each bringing payment to 90 percent of the amount then due, and the balance within 60 days of final redemption

Installments at least once a year, each bringing payment to 100 percent of the amount then due, and the balance within 60 days of final redemption

Installments at least once every five years, each bringing payment to 100 percent of the amount then due, and the balance within 30 days of final redemption

Installments at least once a year, each bringing payment to 90 percent of the amount then due, and the balance within 30 days of final redemption

A small town with general taxing powers expects to issue 4 million dollars of new-money governmental bonds this year and also to carry out a current refunding of 3 million dollars of its bonds with 3 million dollars of refunding bonds. For the small-issuer rebate exception, how do the two compare?

Both count toward the 5 million dollar limit, so the town's expected issuance of 7 million dollars takes it outside the exception for the year

The new-money bonds count toward the 5 million dollar limit, while the refunding bonds are left out because they do not exceed the bonds refunded

Neither counts toward the 5 million dollar limit, since only private activity bonds are counted in deciding whether an issuer is a small one

The refunding bonds count toward the 5 million dollar limit, while the new-money bonds are left out because they finance local activities

In 2016 an issuer sells tax-exempt advance refunding bonds. Open-market securities bought for the escrow would yield more than the restricted yield, and SLGS are on sale. May the issuer keep the investments and bring their yield down with a yield reduction payment?

Yes, provided the issuer pays the excess in advance, when it funds the escrow on the refunding issue's issue date

Yes, a yield reduction payment being available for any investment whose yield exceeds the restricted yield on the issue

Generally not, such payments being unavailable for advance refunding proceeds outside listed cases such as a SLGS sales suspension

Generally not, such payments being open only to issuers that qualify for the small-issuer exception from rebate

An escrow later proves insufficient to pay a refunded issue in full. How does the issuer's position differ according to whether the issue was legally defeased or only economically defeased?

After either one the holders' lien on the pledged revenues has ended, the two differing only in who verifies the escrow

After a legal one it must still pay from the pledged revenues; after an economic one the holders' lien on them has ended

After either one it must still pay from the pledged revenues, the two differing only in how the escrow is invested

After an economic one it must still pay from the pledged revenues; after a legal one the holders' lien on them has ended

Why are refunded bonds generally not considered part of the issuer's debt after a refunding?

Their interest has become taxable, and only tax-exempt obligations are counted toward an issuer's reported debt

Their holders have surrendered the bonds to the escrow agent in exchange for an equal par amount of refunding bonds

Their principal was repaid in full on the date of the refunding, the bonds staying outstanding only in name

Part of a refunding escrow funded from tax-exempt bonds is held, pending use, in Demand Deposit SLGS certificates of indebtedness. How do the regulations treat those certificates for the arbitrage rules of section 148?

As investment property, so that their yield is limited to the yield on the refunding issue like the escrow's other securities

As tax-exempt bonds rather than investment property, so that their yield is not limited to the yield on the refunding issue

As taxable investments, so that all of their earnings must be paid to the United States as rebate whatever their yield

As replacement proceeds of the prior issue, so that their yield is limited to the yield on the prior issue instead

An issuer with a continuing disclosure undertaking under SEC Rule 15c2-12 defeases part of an outstanding issue. When must notice of the defeasance be provided?

Within thirty days after the defeasance occurs, by a supplement to the final official statement

With the next annual financial information that the undertaking requires the issuer to file

In a timely manner not more than ten business days after the defeasance occurs

Only once the defeased bonds have been paid from the escrow, which may be years after the defeasance

Refunding proceeds will provide for 20 million dollars of a 50 million dollar outstanding maturity that carries a single CUSIP number, the refunded part to be redeemed on a 2029 call date. What does MSRB Rule G-34 require of the dealer?

A written application to the Board's designee for a new CUSIP number for the refunding bonds, and nothing more

A notice to EMMA that the maturity is now partly refunded, the one CUSIP number continuing to cover all of it

A request to the issuer to retire the unrefunded part, since a maturity may not remain refunded only in part

A written application to the Board's designee to reassign a CUSIP number to the part refunded to that date and price

Advance Refunding and Defeasance of Municipal Bonds: Section 149(d), Escrows and SLGS

What Are Advance Refunding and Defeasance of Municipal Bonds?

A refunding is the procedure by which a state or local government refinances bonds it already has outstanding by selling new bonds. The new bonds are the refunding bonds, and the outstanding bonds being refinanced are the refunded bonds, also called the prior issue. In a current refunding the proceeds of the new bonds are used promptly, typically within 90 days, to retire the outstanding bonds. In an advance refunding the proceeds are instead deposited in an escrow that pays debt service on the outstanding bonds as it falls due, so for a time both issues are outstanding.

Defeasance is the legal event that usually accompanies an advance refunding: once provision has been made for future payment, the bondholders' rights and their lien on the pledged revenues come to an end under the terms of the bond contract. The subject draws on federal tax law (Internal Revenue Code sections 148 and 149 and the regulations at 26 CFR 1.148 and 1.150-1), the Treasury's SLGS program (31 CFR part 344) and municipal disclosure rules.

Why Issuers Refund and How Savings Are Measured

The MSRB identifies two general reasons for a refunding. The first is to reduce the issuer's interest costs, by replacing bonds that carry a higher rate with bonds sold at a lower one. The second is to remove a burdensome or restrictive covenant imposed by the terms of the bonds being refinanced. The second reason does not depend on interest rates at all, so an issuer can have a sound reason to refund even when market rates have not fallen.

Where the motive is interest cost, the result is usually expressed as present value savings: the difference, in current dollars, between the debt service on the refunded issue and the debt service on the refunding issue, found by discounting the difference in the future debt service payments on the two issues at a given rate.

For federal tax purposes a refunding issue is an issue of obligations whose proceeds are used to pay principal, interest or redemption price on another issue, including issuance costs, accrued interest and a reserve fund properly allocable to it. The other issue is the prior issue, and the regulations state that a prior issue may be issued before, at the same time as, or after the refunding issue.

Current and Advance Refundings Under Section 149(d) and the Regulations

Section 149(d)(2) of the Internal Revenue Code treats a bond as issued to advance refund another bond if it is issued more than 90 days before the redemption of the refunded bond. The regulations at 26 CFR 1.150-1(d) state the same line in terms of the use of proceeds. A current refunding issue is a refunding issue issued not more than 90 days before the last expenditure of any proceeds of the refunding issue for the payment of principal or interest on the prior issue, and an advance refunding issue is simply any refunding issue that is not a current refunding issue. The count therefore runs to the final use of refunding proceeds on the prior issue, not to the first.

The window was once wider: a refunding issue issued before 1986 is a current refunding if it was issued not more than 180 days before that last expenditure.

The federal tax meaning is not the only one in use. The MSRB notes that a refunding in which the refunded bonds are outstanding for less than 90 days is not an advance refunding for federal tax purposes but may still be an advance refunding under state law, or under bond contract provisions that require specified comfort that the escrow securing the refunded bonds is adequate.

Transactions the Regulations Do Not Treat as Refundings

The regulations carve several transactions out of the refunding definition. An issue is not a refunding issue if the only principal and interest it pays is interest on another issue that accrues during a one-year period including the issue date of the new issue, that is a capital expenditure, or that is a working capital expenditure within a de minimis rule.

Nor is an issue a refunding issue to the extent that the obligor of one issue is neither the obligor of the other issue nor a related party with respect to that obligor.

A third exception covers asset acquisitions. If, within six months before or after a person assumes obligations of an unrelated party in connection with an asset acquisition, the assumed issue is refinanced, the refinancing issue is not treated as a refunding issue. Where none of these specific rules settles the question, the regulations direct that whether an issue is a refunding issue is decided by the substance of the transaction in light of all the facts and circumstances.

The Tax Cuts and Jobs Act of 2017 and the End of Tax-Exempt Advance Refundings

Before 2018, section 149(d)(1) denied tax exemption only to a bond issued as part of an issue described in its paragraphs (2), (3) or (4), which addressed certain private activity bonds, other refunding bonds, and bonds involved in abusive transactions. An advance refunding that stayed outside those described categories could be done with tax-exempt bonds.

Section 13532 of Public Law 115-97, enacted on 22 December 2017, rewrote paragraph (1) so that nothing in section 103(a) or any other provision of law is to be construed to exempt from federal income tax the interest on any bond issued to advance refund another bond. It struck the former paragraphs that had set out those categories and the special rules for bonds issued before 1986. The amendment applies to advance refunding bonds issued after 31 December 2017.

The change replaced a denial confined to listed categories with a denial that reaches every advance refunding bond, governmental and private activity bonds alike.

Taxable Advance Refundings and Taxable Exchangeable Bonds

The 2017 amendment denies tax exemption; it does not forbid an issuer from advance refunding. Under 26 CFR 1.150-1(b) a taxable bond is any obligation the interest on which is not excludable from gross income under section 103, and an issuer may still sell such bonds to advance refund its tax-exempt debt.

A taxable advance refunding does not lose access to the Treasury's special escrow securities. The SLGS regulations define an eligible source of funds by a list. Besides gross proceeds of tax-advantaged bonds, it covers the proceeds of a bond issue that is not an issue of tax-advantaged bonds but that refunds, or is refunded by, an issue of tax-advantaged bonds, and amounts held together with gross proceeds of tax-advantaged bonds in a refunding escrow or defeasance escrow; its last item reaches only other amounts subject to yield limitations under the tax rules for tax-advantaged bonds. The escrow for a taxable refunding of tax-exempt bonds may therefore be invested in SLGS.

A related structure is the taxable exchangeable bond, which the MSRB says is sometimes called a Cinderella bond. It is issued on a taxable basis at the outset and converts to tax-exempt status when a specified condition precedent occurs, such as an allocation of volume cap becoming available or the occurrence of certain refundings.

Forward and Synthetic Refundings

The MSRB lists several methods of achieving the same practical effect as an advance refunding. In a forward refunding the issuer agrees, usually with an underwriter, to issue bonds on a specified future date, and the underwriter agrees to buy them on that date; the proceeds, when the bonds are issued, are used to refund the issuer's outstanding bonds. A forward settles at a future date on terms fixed when it is executed, so the issuer secures today's market terms for a refunding it cannot carry out today; the MSRB describes forwards used to refund an outstanding issue that cannot be advance refunded.

A synthetic refunding is an arrangement that lets an issuer generate the debt service savings it would realize if it were permitted to advance refund its outstanding bonds. The issuer generally enters into an agreement with a counterparty and receives an upfront payment in return for a specified action, or a right for the counterparty to take a specified action, at a future date, typically a date on which the issuer can call the outstanding bonds and effect a current refunding. On that date the counterparty may, for example, be able to require the issuer to issue refunding bonds on specified terms for the counterparty to buy.

Crossover Refundings

A crossover refunding is a method of advance refunding in which the revenue stream originally pledged to secure the refunded bonds continues to be used to pay debt service on the refunded bonds until they mature or are called. Only at that crossover date do the pledged revenues switch to paying debt service on the refunding bonds, and only then are the escrowed securities used to pay off the refunded bonds.

While both issues are outstanding, debt service on the refunding bonds is paid from the interest earnings on the invested proceeds of the refunding bonds, not from the pledged revenues. The structure differs from the conventional advance refunding, in which the refunded bonds are typically secured solely by an escrow funded with the refunding proceeds from the day the escrow is established.

Structuring the Refunding Escrow

An escrow account is a fund established to hold funds pledged and to be used solely for a designated purpose, typically to pay debt service on an outstanding issue in an advance refunding. The escrow deposit agreement provides for the deposit of funds or securities into it and sets out how those funds are to be invested pending their expenditure, together with the schedule on which ongoing debt service payments and any early redemptions are to be made. The MSRB calls that agreement, or its equivalent, the advance refunding document, which MSRB Rule G-32 requires to be submitted to EMMA.

The escrow can be sized in different ways. In a net cash refunding the proceeds of the refunding bonds and any other available funds, together with the interest earned on them, are required to produce enough to pay debt service on the refunded bonds, so investment earnings carry part of the load. Whatever the sizing, a verification report is commonly obtained: a report by a certified public accountant or other independent third party that verifies the yield on the investments held in escrow and demonstrates that the cash flow from them is sufficient to pay the principal of and interest on the refunded bonds being defeased.

For tax purposes a refunding escrow means one or more funds established as part of a single transaction or a series of related transactions, containing proceeds of a refunding issue and any other amounts, to provide for payment of principal or interest on one or more prior issues. Funds are generally not treated as so established solely because proceeds of an issue and replacement proceeds of the prior issue were deposited more than six months apart, or because proceeds of completely separate issues were deposited in one escrow.

State and Local Government Series Securities

State and Local Government Series securities, known as SLGS and pronounced slugs, are non-marketable Treasury securities that the Secretary of the Treasury offers to issuers of tax-advantaged bonds to provide investments that assist them in complying with the Internal Revenue Code. The MSRB notes they are most commonly used for escrows in connection with refunding bonds. They are held in book-entry form on the books of the Bureau of the Fiscal Service and cannot be transferred by sale, exchange, assignment, pledge or otherwise.

SLGS come in two types. Time Deposit securities are issued as certificates of indebtedness, notes or bonds, with maturities the issuer fixes: from fifteen days to one year for certificates that bear no interest, thirty days to one year for interest-bearing certificates, one year and one day to ten years for notes, and ten years and one day to forty years for bonds. Demand Deposit securities are one-day certificates of indebtedness rolled over automatically each day until redemption is requested, bearing a rate based on an adjustment of the average yield on 13-week Treasury bills at the most recent auction. Both are issued in a minimum amount of 1,000 dollars.

The issuer designates a rate for each Time Deposit security that may not exceed the maximum shown in the daily SLGS rate table. The SLGS rate is the current Treasury borrowing rate less one basis point, and where that adjustment would produce a negative rate the SLGS rate is set at zero. The table that applies to a subscription is the one in effect on the business day the subscriber starts the subscription process, which fixes the rate available to the escrow at that point.

Subscribing for, Changing and Redeeming SLGS

Subscriptions go through the Fiscal Service's SLGSafe site. The subscriber sets an issue date, which must be a business day and cannot be more than 60 days after Treasury receives the subscription. A subscription for 10 million dollars or less must be received at least five days before the issue date, and one for more than 10 million dollars at least seven days before it.

The rules are built to stop issuers using SLGS as a free option on interest rates. A cost-free option is any use of the SLGS program to exploit movements in interest rates, and creating one is prohibited. A subscription cannot be cancelled unless the issuer establishes to Treasury's satisfaction that cancellation is required for reasons unrelated to creating a cost-free option. The regulations give the example of an issuer that both contracts for marketable securities and subscribes for SLGS for one escrow, planning to cancel whichever proves the worse bargain when rates move; that is prohibited. Each Time Deposit subscription also carries a duration certification that the term is no longer than is reasonably necessary to accomplish the issuer's governmental purpose.

A Time Deposit note or bond may be redeemed at the owner's option no earlier than 30 days after its issue date, and a certificate of 30 days or more no earlier than 25 days after it, on a request received 14 to 60 days before the redemption date. For securities subscribed for on or after 28 October 1996, the remaining interest and principal payments are discounted at the current Treasury borrowing rate for the remaining term, which can produce a premium or a discount to the issuer depending on whether that rate is lower or higher than the security's stated rate. A zero interest security is redeemed for the principal invested.

Open-Market Escrow Purchases

An issuer may instead fund an escrow with marketable securities, defined in the SLGS regulations as any security other than a SLGS security, such as other Treasury and federal agency securities.

On its purchase date, a Treasury obligation bought directly from the Treasury, including a SLGS security, is valued at its purchase price; on any later date a SLGS security is valued at its redemption price for redemption on that date. For investments bought for a yield restricted defeasance escrow through a competitive bidding procedure, the safe harbor requires among other things that the lowest cost bona fide bid, including any broker's fees, be no greater than the cost of the most efficient portfolio made up only of SLGS, measured at the time bids are due.

That comparison depends on SLGS being available. If SLGS cannot be bought on the day bids are due because Treasury has suspended sales, the regulations do not require the comparison with a SLGS portfolio.

Yield Restriction on Refunding Escrows

Section 148(a) makes a bond an arbitrage bond, and its interest taxable, if any portion of the issue's proceeds is reasonably expected to be used to acquire higher yielding investments, and section 148(b) defines those as investment property producing a yield over the term of the issue that is materially higher than the yield on the issue. The arbitrage regulations then define materially higher by type of investment.

For most investments, materially higher means one-eighth of one percentage point. For investments in a refunding escrow, and for investments allocable to replacement proceeds, it means one-thousandth of one percentage point, leaving a refunding escrow almost no room above the bond yield. Where yield restricted investments in the same class are subject to different definitions, the definition that produces the lowest permitted yield applies to all of them.

The opposite case is negative arbitrage, which the MSRB defines as investment of bond proceeds and related funds at a rate below the bond yield. For section 148 purposes the regulations also treat a Demand Deposit SLGS certificate of indebtedness as a tax-exempt bond, and investments that are tax-exempt bonds and not investment property under section 148(b)(3) face no yield limitation.

Temporary Periods and Transferred Proceeds

Proceeds may be invested above the bond yield during a temporary period, and refunding issues have their own rather than the general ones for capital projects. The temporary period for proceeds of a refunding issue, other than transferred proceeds, ends 30 days after the refunding issue's issue date. For a current refunding issue it is 90 days, except that a current refunding issue with an original term to maturity of 270 days or less is limited to 30 days, and all such short-term current refundings in the same series share an aggregate of 90 days.

An advance refunding also cuts short the prior issue's own temporary period. The initial temporary period for proceeds of a prior issue that is refunded by an advance refunding issue, including amounts that become transferred proceeds, terminates on the issue date of the advance refunding issue.

Transferred proceeds arise because unspent money from the old bonds follows the debt. When proceeds of the refunding issue discharge any of the outstanding principal of the prior issue, proceeds of the prior issue become transferred proceeds of the refunding issue and cease to be proceeds of the prior issue. The amount transferred is the prior issue's proceeds on the date of discharge multiplied by a fraction whose numerator is the principal discharged on that date and whose denominator is the total outstanding principal of the prior issue immediately before it.

Arbitrage Rebate in Refundings

Section 148(f) requires an issuer to pay the United States the excess of what it earned on nonpurpose investments over what it would have earned had those investments yielded the bond yield, plus income attributable to that excess. Payment is due in installments made at least once every five years, each large enough that 90 percent of the amount then owed has been paid, and the last installment is due no later than 60 days after the last bond of the issue is redeemed, for the remaining balance.

Small governmental issuers are excused from rebate where, among other conditions, they reasonably expect to issue no more than 5 million dollars of tax-exempt governmental bonds in the calendar year. A bond issued to refund another bond, other than to advance refund it, is left out of that count to the extent its amount does not exceed the outstanding amount of the refunded bond, so a current refunding of the same size does not use up a small issuer's capacity.

A refunding portion of an issue is treated as a separate issue for this exception and qualifies only if its aggregate face amount does not exceed 5 million dollars, each refunded bond was itself issued under the small issuer exception, the average maturity of the refunding bonds is not later than that of the bonds refunded, and no refunding bond matures more than 30 years after the original bond was issued.

Yield Reduction Payments on Refunding Escrows

A yield reduction payment is an amount paid to the United States that the regulations treat as a payment for an investment, lowering its yield to fit the yield restriction; it is paid when and as rebate is. It is not available for every investment: the rule applies only to investments in a listed set of categories, and, except where a category expressly provides otherwise, only to investments allocated to proceeds of an issue other than gross proceeds of an advance refunding issue. An advance refunding escrow therefore cannot ordinarily be invested above the restricted yield and then corrected by paying the excess to the Treasury. Because interest on advance refunding bonds issued after 31 December 2017 cannot be tax-exempt, this limit now matters for the escrows of advance refunding issues sold as tax-exempt bonds before 2018.

Several listed categories expressly reach advance refundings. One covers nonpurpose investments allocable to transferred proceeds of an advance refunding issue, to the extent that investing the refunding escrows allocable to the issue's other proceeds in zero-yielding nonpurpose investments is insufficient to satisfy the yield restriction. Another covers investments of an issue, including an advance refunding issue, bought when on the date of the purchase agreement the issuer is unable to subscribe for SLGS because the Bureau of the Fiscal Service has suspended sales.

Legal Defeasance and Economic Defeasance

In the MSRB's usage, defeasance is the termination of certain of the rights and interests of the bondholders, and of their lien on the pledged revenues or other security, in accordance with the terms of the bond contract. This is sometimes called a legal defeasance. It usually occurs in connection with a refunding, after provision has been made for future payment of all obligations on the outstanding bonds, often from the proceeds of a new series of bonds.

Where the bond contract does not provide a procedure for terminating those rights and that lien other than by paying all the outstanding debt in full, funds deposited for future payment may free the pledged revenues for other purposes without effecting a legal defeasance. That is an economic or financial defeasance. If the deposited funds prove insufficient, the issuer remains legally obligated to pay the debt from the pledged revenues.

Following a refunding, refunded bonds are generally not considered part of the issuer's debt, because the lien of their holders is, in the first instance, on the escrowed funds rather than on the revenues originally pledged.

Pre-Refunded and Escrowed-to-Maturity Bonds

Advance refunding proceeds are generally invested in Treasury or federal agency securities, whose principal and interest, with limited exceptions, pay the refunded issue. How long the escrow runs gives the refunded bonds their market label.

Bonds are escrowed to maturity when the escrow is sized to pay principal and interest on the refunded bonds on their original interest payment and maturity dates. An issuer may nonetheless expressly reserve the right, following procedures the SEC has delineated, to call bonds that have been escrowed to maturity early. Bonds are prerefunded when the escrow runs only to a call date or dates on the refunded issue and the bonds are redeemed at that time. MSRB Rule G-15 governs how each is shown on a customer confirmation.

Disclosure of Refundings and Defeasances

Where SEC Rule 15c2-12 applies, the issuer's continuing disclosure undertaking must provide notice of listed events in a timely manner not in excess of ten business days after the event occurs. Defeasances are one of the listed events, alongside bond calls and tender offers. The MSRB notes that these filings are sometimes called material event notices even though a materiality standard applies to only certain of the listed events.

A refunding of less than all the outstanding bonds of an issue is a partial refunding, and it changes how the remaining bonds must be identified. Under MSRB Rule G-34, where the proceeds of a new issue will be used to refund part but not all of an outstanding issue that was assigned a single CUSIP number, to one or more redemption dates and prices, or to refund all of an issue to more than one redemption date and price, the dealer must apply in writing to the Board's designee for a CUSIP number to be reassigned to each part refunded to a particular redemption date and price.

Common Errors and Exam Traps

Candidates often treat any refunding that uses an escrow as an advance refunding for tax purposes, when the tax line is 90 days measured to the last use of refunding proceeds on the prior issue. Others read the 2017 amendment as a ban on advance refunding, when it removed only the tax exemption; taxable, forward and synthetic structures remain. Economic defeasance is not legal defeasance: only the latter ends the holders' lien. And the one-eighth of a point allowance does not apply to a refunding escrow, whose allowance is one-thousandth of a point.

Examination Relevance and Key Takeaways

The key points: a refunding is advance when the refunding bonds are issued more than 90 days before the refunded bonds are redeemed; interest on advance refunding bonds issued after 2017 is taxable; escrows are usually invested in SLGS or other Treasury and agency securities under a tight yield restriction; defeasance ends the holders' lien only where the bond contract provides for it; and defeasances are a listed event for continuing disclosure notices.