Corporations and governmental entities issue bonds in order to borrow money from investors. The bonds require the issuer to pay interest and repay the principal on appointed dates. Bond defeasance is a method used to pay out a bond's cash flows using substitute bonds. Issuers often use bond defeasance to save money or achieve other desirable outcomes.
Some Important Definitions
Experts define "defeased" as meaning nullified. Specifically, bond contracts often contain a defeasance clause that describes how bondholders can be assured of receiving the bond's promised interest and payments up to a given date without causing the bond issuer to pay any prepayment penalties. The given date for principal repayment is either the bond's maturity date or an earlier date known as the call date. On the call date, the issuer can recall the bonds by paying back the principal and any interest due.
How Defeasance Works
A bond issuer may want to nullify its obligation to carry certain issued bonds on its balance sheet, where they are listed as liabilities. Defeasance is a process in which the issuer buys Treasury bonds, places them in an irrevocable escrow account and uses them to pay out the interest and principal promised by the original issued bonds. These substitute payments continue throughout the "defeasance period," meaning the period extending to the bond's call date (if it has one) or maturity date. Defeasance allows the issuer to remove the bonds from its balance sheet because the escrow account offsets the obligation to pay the bonds' cash outflows.
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Municipal Bond Defeasance
Municipal bond defeasance involves the use of "pre-refunding bonds," which are bonds issued to pay the obligatory cash outflows of an earlier bond issue. The earlier issue is a callable bond, and the pre-refunding bonds are used to pay interest and repay principal until the earlier issue's call date. The issuer uses the proceeds from the issuance of the pre-refunding bonds to buy Treasury bonds, which are placed into a defeasance escrow account.
On each interest payment date, the issuer uses the interest and principal in the escrow account to pay the original bond's interest due. On the call date, the issuer uses the remaining balance in the escrow account to repay the original bond's principal, at which time the issuer cancels the original bonds.
Motivation for Bond Defeasance Clause
When investors buy bonds, they count on a certain return on their investment, usually consisting of fixed interest payments at defined intervals plus repayment of principal at the call or maturity date. That return is called the yield-to-call (YTC) or yield-to-maturity (YTM). If the bond issuer prepays the bond early, investors do not receive all the interest they expected to collect. The truncated interest payments result in a yield below the YTC or YTM.
Investors will be less willing to buy prepayable bonds unless their yield is assured. A bond defeasance ensures that yield if the bonds are prepaid, thereby facilitating the issuance of these bonds at a higher price.
Benefits of Bond Defeasance
The removal of a bond issue from the issuer's balance sheet strengthens the issuer's financial condition by reducing its liabilities. Sometimes, the ability of an issuer to issue new bonds is limited by covenants (i.e., agreements) written into existing bond contracts. These covenants may restrict the issuer from taking on debt beyond a certain limit. Defeasance removes existing debt from the balance sheet, which may allow the issuer to issue new bonds without breaking bond covenants.
Bond issuers may also want to prepay bonds when interest rates drop. Issuing new, lower-interest bonds to replace older, higher-interest ones will save the issuer interest expense. However, the bond issue may allow for penalties that the issuer must pay investors when the issuer repays the bonds before the call/maturity date. Defeasance allows issuers to take advantage of lower interest rates without incurring prepayment penalties.