What Is Escrowed to Maturity?

Escrowed to maturity refers to the placement of funds from a new bond issue into an escrow account to pay off an older bond's periodic coupon payments and, ultimately, the principal on its maturity date. The money that grows in the escrow account is eventually used to pay down the original bond, which helps issuers borrow at lower rates.

Key Takeaways

  • Escrowed to maturity refers to the placement of funds from a new bond issue in an escrow account to pay off an older bond's periodic coupon payments and principal.
  • Escrowed to maturity municipal bonds are a form of pre-funded municipal bonds, which are backed by Treasury securities held in an escrow account.
  • The holders of escrowed to maturity bonds possess the tax-advantaged treatment of a municipal bond with the relative safety of a government-issued security.
  • Escrowed to maturity bonds also come with the relative safety of a government-issued security as that is the underlying asset.
  • Investors typically receive a better after-tax yield from escrowed to maturity bonds than they would on a bond with similar duration and risk.

Understanding Escrowed to Maturity

Escrowed to maturity describes the process of an issuer investing and holding the proceeds from new bond sales in an escrow account to cover the existing obligations to the holders of a previously issued bond.

Escrowed to maturity municipal bonds are a form of pre-funded municipal bonds, which are backed by Treasury securities held in an escrow account. In this case, the issuer holds proceeds from a new bond issue in an escrow account and invests them in high credit securities to fund the interest and principal payments to the original bondholder. 

Pre-funded municipal bonds help an issuer receive a better credit rating on its debt. Because state-issued municipal bonds are not backed by the full faith of the U.S. government, the quality of the underlying assets is important to ensure continued interest payments and to minimize the risk of default.

The bonds are pre-funded because the issuer does not have to generate any income to pay the coupon to investors. Payments are made through the escrow account that contains the Treasury securities that generate interest to pay the coupon. As such, the bond and the Treasury securities tend to have the same maturity. Pre-funded bonds help municipal issuers reduce their long-term borrowing costs.

Utilizing Escrowed to Maturity

Pre-funded municipal bonds, which include escrowed to maturity bonds, are securities that a bond issuer has called, or bought back, from the bondholder before it has matured. Issuers often make calls during periods of declining interest rates. By paying off their high-interest debt, the issuer can sell new bonds at lower rates.

However, most bonds contain provisions that prevent the issuer from making that call before a specific date, typically some years after they’ve been issued. So if the issuer wants to take advantage of lower rates before that call date arrives, they might use pre-funded bonds.

With escrowed to maturity bonds, the issuer sells new bonds to cover the cost of calling those bonds that they’ve already issued. On reaching the call date of the original bonds, the issuer uses proceeds from the new bond sales to pay their owners.

The issuer usually invests proceeds from the distribution of the new bonds in U.S. Treasuries and holds them in an escrow account. By selecting Treasuries that mature at the same time that the issuer wants to call the original bonds, they can repay the principal and full interest owed at maturity of the outstanding bond to the original bondholders.

Benefits of Escrowed to Maturity

Escrowed to maturity bonds are unique in that they possess the tax-advantaged treatment of a municipal bond with the relative safety of a government-issued security. This results in a potentially better after-tax yield than an investor would receive on a bond with similar duration and risk.

For example, you’re choosing between a two-year Treasury and a municipal bond with an original maturity of 10 years escrowed to maturity in two years. It is likely that called municipal bonds will offer a superior yield to the Treasury, and the interest payments will be free of both state and federal taxes.