Refunding Escrow Deposits (REDs)

What Are Refunding Escrow Deposits (REDs)?

Refunding escrow deposits (REDs) are a type of forward financial contract that makes an obligation for investors to purchase a specific bond issue at a predefined yield at some date from here on out.

The money from investors is held in escrow and is utilized to purchase interest-bearing U.S. Treasuries, which are either sold or permitted to mature, giving proceeds to be invested into the new bond issue with an interest rate that is locked in with a forward contract.

Investors partake right off the bat in the new bond issue, typically a municipal bond, however will briefly receive taxable income from the Treasury held in escrow.

Understanding Refunding Escrow Deposits (REDs)

Refunding escrow deposits permit investors and underwriters to dodge limitations in the tax code that don't consider certain municipal bond issues to be pre-refunded. Pre-refunding is a common strategy for issuers of municipal debt, as minor swings in interest rates can amount to a great many dollars in saved interest.

Changes to U.S. tax law during the 1980s restricted tax-exempt pre-refunding for certain types of municipal debt. To get around those new rules, a forward purchase contract can be utilized to secure a lower funding rate, rather than a subsequent bond issue. Money reserved to repay greater expense debt at the next call date is put into escrow with this approach.

As Nasdaq makes sense of, forward contracts, for example, REDs mean that investors are committed to buy bonds, when initially issued, at a given rate. The first-issued date is equivalent to the primary discretionary call date on an existing high-rate bond. Initially, the investors' funds will be invested in secondary market Treasury bonds. The booking is to such an extent that the Treasuries will mature close to the call date on the existing bonds. This gives the source of the funds expected to purchase the new issue and reclaim the former one.

History of Refunding Escrow Deposits

The potential for REDs was investigated in a 1989 article in The New York Times. "New financial instruments that go by the far-fetched name of REDs, or refunding escrow deposits, empower issuers of tax-exempt bonds to lock to the present greatest advantage rates for bond issues a long time down the road," composed Richard D. Hylton.

Hylton proceeded to make sense of that federal tax changes in 1984 got rid of the tax-exempt advance refunding of certain sorts of bonds utilized specifically for state or municipal undertakings. After the tax changes produced results, issuers of tax-exempt bonds required a method for exploiting interest rate reductions. Municipal forwards or REDs were a helpful method for achieving this goal.

The changes to the tax code meant bonds issued for many undertakings — like the building of air terminals, roadways, and required infrastructure improvements — couldn't be advance refunded. Bond issuers could never again exploit falling interest rates by giving new debt to retire the old debt.

In the previous situation, a municipality could issue extra bonds for a convention center and "put the proceeds in more lucrative Treasury bonds to retire the old debt at the discretionary call date," said Hylton. "Since there would be two bond issues outstanding, two times as numerous investors would appreciate tax-exempt status."

Fostering a New Financial Instrument

These limitations prodded investment bank First Boston to create a financial instrument that locked in interest rates while at the same time postponing the giving of the new bonds until the discretionary call date of the original issue. This meant investors would consent to a forward-purchase arrangement expecting them to purchase the bonds when issued.

In the interim, the investors' funds would be utilized in the secondary market to purchase Treasury bonds. These bonds are held in escrow and pay an annual income that is taxable. The maturity date of the Treasuries roughly compares with the discretionary call date for the outstanding bonds. The escrow agent utilizes the money from the Treasuries to buy new bonds with a lower interest rate.

Features

• Investors' funds are utilized in the secondary market to purchase Treasury bonds, which are held in escrow and pay an annual taxable income.
• The Treasuries maturity date generally relates with the discretionary call date for the outstanding bonds, which empowers the escrow agent to utilize the money from the Treasuries to buy new bonds with a lower interest rate.
• REDs are financial instruments that empower bond issuers to lock in lower interest rates and postpone the giving of new bonds until the discretionary call date of the original issue.
• Refunding escrow deposits (REDs) are forward purchase contracts that require the investor to buy a specific bond at a certain yield at some date from here on out.
• REDs appeared after federal tax law changes in 1984 wiped out the tax-exempt pre-refunding of certain sorts of bonds utilized for state or municipal undertakings.