What Does Refunding Escrow Deposit Mean?
Refunding escrow deposits (REDs) refers to 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-refundings 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 future date coincides with the first optional call date on an existing high-rate bond. In the interim, investors' money is invested in secondary market Treasury bonds. The Treasuries mature around the call date on the existing bonds, providing the money to buy the new issue and redeem the old one."
History of Refunding Escrow Deposits
The potential for REDs were 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.
"Since the federal tax changes of 1984 eliminated the tax-exempt advance refunding of bonds used for certain kinds of state or municipal projects, Wall Street's public finance departments have looked for a way to help issuers of tax-exempt bonds take advantage of falling interest rates," he explained.
"REDs or municipal forwards do just that. Because of the tax-code changes, bonds issued for projects like airports, solid-waste-disposal systems, wharves and convention centers cannot be refunded in advance. That is, issuers cannot simply issue new debt as interest rates fall to retire the old debt, creating more outstanding issues."
In situations such as a those, 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.
"In an attempt to deal with the new restrictions, First Boston's public finance people came up with an instrument that locks in low rates without actually issuing the new bonds until the optional call date of the original issue," he added. "Investors sign a forward-purchase agreement to buy the bonds when they are issued, and in the meantime the investors' money is used to buy Treasury bonds in the secondary market. These are held in escrow and pay out a taxable annual income. The optional call date for the outstanding bonds roughly coincides with the maturity of the Treasuries, and the money from the Treasuries is used by the escrow agent to buy new bonds with a lower interest rate."