Defeasance of municipal bonds.

defeasance

noun

1. A rendering void; an annulment.

2. a. The voiding of a contract or deed. b. A clause within a contract or deed providing for annulment.

Summary

When referring to municipal bonds, a defeasance relates to methods by which an outstanding bond issue can be made void, both legally and financially. Although a defeasance is generally the outcome of a refunding transaction, a defeasance can also be accomplished with cash rather than the issuance of any bonds. This article focuses on the concept of a defeasance and the use of cash for this purpose.

General Description

A defeasance is a financing tool by which outstanding bonds may be retired without a bond redemption or implementing an open market buy-back. Cash is used to purchase government securities. The principal of and interest earned on the securities are sufficient to meet all payments of principal and interest on the outstanding bonds as they become due.

Essentially, defeasance allows an issuer to collateralize outstanding debt with a portfolio of "risk-free government securities", thereby instantly removing the debt from the issuer's balance sheet. This occurs because the government securities generate the cash flow needed to pay all interest and principal on the outstanding bonds when due. Under generally accepted accounting principles, if the portfolio of securities includes only high quality securities such as direct obligations of the United States Government, the bonds are treated as "defeased" or legally retired. (See FASB Statement No. 76, Advance Refunding and Defeasance Policy and GASB Statement No. 7).

In a legal context, defeasance renders the outstanding bonds paid thereby removing all obligations of the issuer for payment of the bonds. In order for a bond issue to be legally defeased the securities selected and the terms of how and where the securities are held (see "Mechanics of Defeasance" below) must meet the requirements set forth in the documents that authorized the outstanding bonds.

If the defeasance is consistent with generally accepted accounting principles and complies with the outstanding bond document requirements, the bonds will no longer treated as debt for accounting purposes nor for purposes of computing any statutory or constitutional debt limitation.

Defeasance often offers greater benefits than other methods of liquidating debt. These benefits are described below.

1. Depending on interest rates and market conditions, defeasance may enable an issuer to extinguish debt at the best possible price. This occurs if the government securities carry a rate at least as high as the outstanding bonds. In some cases the investments may not be subject to yield restrictions. Furthermore, no redemption premium is incurred.

2. Defeasance doesn't penalize the bondholder. In fact, the bondholders benefit because the bonds are not redeemed and are secured by a portfolio of risk-free government securities.

3. Defeasance does not require lengthy or costly proceedings, as is often the case with tender offerings.

4. Defeasance does not require the issuance of new debt.

Mechanics of Defeasance

In a defeasance, the issuer purchases government securities for deposit in an escrow account. The escrow account is held by a bank or trust company that serves as escrow agent. Under the terms of an escrow agreement, the government securities are irrevocably pledged to the payment of the outstanding bonds. The government securities are in a principal amount such that the principal and interest earned are sufficient to retire the principal of and interest on the outstanding bonds as they come due. The government securities and all costs related to the defeasance are paid with funds accumulated in the various accounts established for the outstanding bonds or with other available funds.

Typical Parties to the Transaction

Bond Counsel: Bond Counsel drafts the escrow agreement and renders an opinion that the outstanding bonds have been legally retired (defeased).

Financial Advisor: WM Financial Strategies develops the financing plan, identifies the government securities to be placed in the escrow account, assists in the arrangements for the acquisition of the government securities, reviews the terms of the escrow agreement, and assists the issuer in the transfer of funds to the escrow agent.

Accountant: Bond Counsel may require an independent certified public accountant to provide an opinion that the escrow account is sufficient to retire the outstanding bonds.

Escrow Agent: The bank or trust company that holds the government securities and makes payments to the paying agent for the outstanding bonds.