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Escrowed to Maturity Definition

What Is Escrowed to Maturity?

Escrowed to maturity refers back to the placement of funds from a brand new bond difficulty into an escrow account to repay an older bond’s periodic coupon funds and, finally, the principal on its maturity date. The cash that grows within the escrow account is ultimately used to pay down the unique bond, which helps issuers borrow at decrease charges.

Key Takeaways

  • Escrowed to maturity refers back to the placement of funds from a brand new bond difficulty in an escrow account to repay an older bond’s periodic coupon funds and principal.
  • Escrowed to maturity municipal bonds are a type of pre-funded municipal bonds, that are backed by Treasury securities held in an escrow account.
  • The holders of escrowed to maturity bonds possess the tax-advantaged therapy of a municipal bond with the relative security of a government-issued safety.
  • Escrowed to maturity bonds additionally include the relative security of a government-issued safety as that’s the underlying asset.
  • Buyers usually obtain a greater after-tax yield from escrowed to maturity bonds than they might on a bond with related period and threat.

Understanding Escrowed to Maturity

Escrowed to maturity describes the method of an issuer investing and holding the proceeds from new bond gross sales in an escrow account to cowl the present obligations to the holders of a beforehand issued bond.

Escrowed to maturity municipal bonds are a type of pre-funded municipal bonds, that are backed by Treasury securities held in an escrow account. On this case, the issuer holds proceeds from a brand new bond difficulty in an escrow account and invests them in excessive credit score securities to fund the curiosity and principal funds to the unique bondholder. 

Pre-funded municipal bonds assist an issuer obtain a greater credit rating on its debt. As a result of state-issued municipal bonds will not be backed by the full faith of the U.S. authorities, the standard of the underlying property is essential to make sure continued curiosity funds and to attenuate the danger of default.

The bonds are pre-funded as a result of the issuer doesn’t need to generate any revenue to pay the coupon to traders. Funds are made by way of the escrow account that comprises the Treasury securities that generate curiosity to pay the coupon. As such, the bond and the Treasury securities are inclined to have the identical maturity. Pre-funded bonds assist municipal issuers cut back their long-term borrowing prices.

Using Escrowed to Maturity

Pre-funded municipal bonds, which embrace escrowed to maturity bonds, are securities {that a} bond issuer has called, or purchased again, from the bondholder earlier than it has matured. Issuers typically make calls during times of declining rates of interest. By paying off their high-interest debt, the issuer can promote new bonds at decrease charges.

Nevertheless, most bonds comprise provisions that forestall the issuer from making that decision earlier than a particular date, usually some years after they’ve been issued. So if the issuer desires to reap the benefits of decrease charges earlier than that decision date arrives, they could use pre-funded bonds.

With escrowed to maturity bonds, the issuer sells new bonds to cowl the price of calling these bonds that they’ve already issued. On reaching the decision date of the unique bonds, the issuer makes use of proceeds from the brand new bond gross sales to pay their house owners.

The issuer normally invests proceeds from the distribution of the brand new bonds in U.S. Treasuries and holds them in an escrow account. By deciding on Treasuries that mature on the similar time that the issuer desires to name the unique bonds, they’ll repay the principal and full curiosity owed at maturity of the excellent bond to the unique bondholders.

Advantages of Escrowed to Maturity

Escrowed to maturity bonds are distinctive in that they possess the tax-advantaged therapy of a municipal bond with the relative security of a government-issued security. This ends in a doubtlessly higher after-tax yield than an investor would obtain on a bond with related duration and threat.

For instance, you’re selecting between a two-year Treasury and a municipal bond with an authentic maturity of 10 years escrowed to maturity in two years. It’s seemingly that referred to as municipal bonds will provide a superior yield to the Treasury, and the curiosity funds will probably be freed from each state and federal taxes.

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