Investment options for advance refunding escrow

Introduction

Traditionally, the proceeds from advance refunding bonds are used to purchase State and Local Government Series (SLGS) securities and placed in an escrow with a third-party agent. Open Market Securities (OMS) or cash may also be used. OMS are U.S. Department of the Treasury (Treasury) and (sometimes) Agency securities purchased in the open market. OMS may generate additional savings for the issuer. The use of a bidding agent may be helpful.

SLGS

SLGS are special-purpose non-marketable securities that the Treasury created for the exclusive use of state and local governments to assist them in complying with federal tax laws and Internal Revenue Service (IRS) arbitrage regulations. In 1969, legislation was passed to end the practice of earning arbitrage profits by investing bond proceeds in higher-yielding investments. 

SLGS rates are set daily and based on yesterday’s closing Treasury rates. Like Treasuries, SLGS maturities range from one month to thirty years. Unlike Treasuries, SLGS rates do not fluctuate intraday; SLGS are priced at par. Also, unlike Treasuries, SLGS can be tailored to mature on the exact dates needed for escrow disbursements. SLGS are subscribed for directly through the Federal Reserve on the day refunding bonds are sold. SLGS and the refunding bonds settle on the same day. 

No SLGS

The Treasury can close the SLGS “window” at its discretion. The window was closed on Mar. 1, 2019, when federal debt reached its ceiling. It reopened on Aug. 5, 2019, after the Bipartisan Budget Act of 2019 suspended the federal debt limit through July 31, 2021.

Taxable municipal bonds can only be refunded with OMS.

OMS

As the name implies, OMS are purchased in the open market to fund an escrow. The indenture of the refunded issue(s) will determine eligible investments. Treasuries trade 24 hours per day. Bond prices fluctuate like stock prices. If today’s bond prices trade lower and yields move higher, then OMS may cost less and yield more than SLGS. Recall that SLGS rates are fixed and based on yesterday’s Treasury rates.  

If there is a sell-off in the bond market on pricing day, OMS should cost less than SLGS. Conversely, if there is a rally in the bond market on pricing day, SLGS may cost less than OMS.       

One very powerful argument for the use of OMS is zero-coupon Treasuries, known as STRIPS (Separate Trading of Registered Interest and Principal of Securities). STRIPS trade at a discount to their face value and mature at par. The difference between the purchase price and par is the investor’s profit, or investment yield.