Refunding Escrow Deposits (REDs)

What Are Refunding Escrow Deposits (REDs)?

Refunding escrow deposits (REDs) are a type of forward financial contract that creates an obligation for investors to purchase a particular bond issue at a specified yield at some date in the future.

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

Investors participate early in the new bond issue, typically a municipal bond, but will temporarily receive taxable income from the Treasury held in escrow.

Understanding Refunding Escrow Deposits (REDs)

Refunding escrow deposits allow investors and underwriters to circumvent restrictions in the tax code that don't allow for 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 millions of dollars in saved interest.

Changes to U.S. tax law in the mid-1980s restricted tax-exempt pre-refunding for certain types of municipal debt. To get around those new rules, a forward purchase contract can be used to secure a lower funding rate, instead of a second bond issue. Money earmarked to repay higher-cost debt at the next call date is put into escrow with this approach.

As Nasdaq explains, forward contracts such as REDs mean that investors are obligated to buy bonds, when first issued, at a given rate. The first-issued date is the same as the first optional call date on an existing high-rate bond. Initially, the investors' funds will be invested in secondary market Treasury bonds. The scheduling is such that the Treasuries will mature near the call date on the existing bonds. This provides the source of the funds needed to purchase the new issue and redeem the old one.

History of Refunding Escrow Deposits

The potential for REDs was explored in a 1989 article in The New York Times. "New financial instruments that go by the unlikely name of REDs, or refunding escrow deposits, enable issuers of tax-exempt bonds to lock in today's low-interest rates for bond issues years down the road," wrote Richard D. Hylton.

Hylton went on to explain that federal tax changes in 1984 did away with the tax-exempt advance refunding of some kinds of bonds used specifically for state or municipal projects. After the tax changes took effect, issuers of tax-exempt bonds needed a way to take advantage of interest rate reductions. Municipal forwards or REDs were a convenient way to accomplish this goal.

The changes to the tax code meant bonds issued for a wide range of projects—such as the building of airports, roadways, and needed infrastructure improvements—could not be advance refunded. Bond issuers could no longer take advantage of falling interest rates by issuing new debt to retire the old debt.

In the previous situation, a municipality could issue additional bonds for a convention center and "invest the proceeds in higher-paying Treasury bonds in order to retire the old debt at the optional call date," said Hylton. "Because there would be two bond issues outstanding, twice as many investors would enjoy tax-exempt status."

Developing a New Financial Instrument

These restrictions spurred investment bank First Boston to develop a financial instrument that locked in interest rates while simultaneously delaying the issuing of the new bonds until the optional call date of the original issue. This meant investors would sign a forward-purchase agreement requiring them to purchase the bonds when issued.

In the interim, the investors' funds would be used 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 approximately corresponds with the optional call date for the outstanding bonds. The escrow agent uses the money from the Treasuries to buy new bonds with a lower interest rate.