Municipalities on both ends of a lease transaction can benefit from the lease.
When an outstanding bond is being refinanced by a refunding bond issue, the proceeds must be dedicated to the refinancing of the refunded bonds. If the refunded debt is not eligible to be redeemed on the date of delivery of the refunding bonds, interest and eventually the principal payment will be required to be made out of an escrow account until the redemption date. To make sure this occurs, the refunding bond proceeds are given to a trustee who buys the securities and places them in an account whose cash flow will pay off the old bonds. The account created by the trustee is called an escrow account.
The escrow account can be active for anywhere from one day to 30 years, depending on the maturity of the bonds being refunded and if the refunded bonds are being called prior to maturity or not.
Example:
A borrower issued callable bonds at a rate of 5.00%. Since the bonds were sold, market interest rates have decreased, and the borrower’s credit rating has improved, meaning it can issue bonds at a considerably lower rate now.
Because the 5.00% bonds are callable, the borrower can pay them off early with the money gained from bonds issued in a lower interest environment. The borrower issues new bonds at a lower interest rate and places the proceeds in an escrow account where the Trustee invests them in low-risk securities such as Treasury securities until principal and interest payments are needed to redeem the original 5.00% bonds.
A lease can be for any term, but a lease must have a term over a definite period of time with a particular starting and ending date.
What’s important here?
An escrow account can hold both cash and securities purchased with either a bond’s proceeds or cash. To ensure the escrow is able to fulfill its legal requirement and prevent future cash flow issues, low-risk securities are deposited in the escrow. These securities, known as allowable investments, are outlined in the bond’s documentation and include state and local government series securities (SLGS), treasury securities, some federal agency securities, and some tax-exempt securities.
In municipal transactions, there are restrictions as to how the escrow can be invested; these restrictions are defined by its permissible reinvestment earnings rate, which is typically the lower of the rate currently achievable on the open market or the arbitrage yield of the refunding bond issue, depending on the type of refunding.
