Defeased Securities: What it Means, How it Works

What Are Defeased Securities?

Defeased securities are securities that have been secured by another asset, such as cash or a cash equivalent in a sinking fund, by the debt-issuing firm which can then nullify its balance sheet obligation.

Defeasance, more generally, is any provision in a contract that voids a bond or loan on a balance sheet when the borrower sets aside cash or other low-risk bonds sufficient enough to service the debt.

Understanding Defeased Securities

A defeased security is a bond which, after its issuance, has its outstanding debt collateralized by cash equivalents or risk-free securities.

The funds used as collateral are sufficient to meet all payments of principal and interest on the outstanding bonds as they become due. If, for some reason, the funds used for defeasance are insufficient to fulfill the future payment of the outstanding debt, the issuer would continue to be legally obligated to make a payment on such debt from the pledged revenues.

For example, the U.S. government could place the funds necessary to pay off a series of Treasury bonds in a trust account specifically created to pay the outstanding bonds upon maturity. The government sets aside these funds to ensure that it has enough cash to pay its bonds when they are due. Commonly, defeased securities are also retractable.

Securities that can be defeased will often carry a lower yield than comparable securities, as obligations on the securities are guaranteed by a fund that has been set aside to disburse payments to the outstanding bondholders. For a risk averse investor, this feature proves beneficial because it lowers the default risk of the security.

Refunding Bonds and Corporate Indentures

Perhaps, the best form of defeasance is observed in refunding bond issues. When a municipal authority decides to redeem an existing bond early due to falling interest rates in the markets, it issues a new bond that reflects the lower financing rate. Issuers prefer to finance their debts at the lowest cost possible; hence, it is not uncommon for higher-coupon bonds to be retired prior to maturity in favor of lower-cost bonds.

However, due to a call protection affixed to callable bonds, a municipal issuer is restricted from buying back outstanding bonds for a period of time. During this lockout period, when bondholders are protected from early redemption, the issuer uses the proceeds from the new issues to buy low-risk Treasury bills. The bills are deposited in an escrow account until the call protection period expires, at which point the Treasuries will be sold to pay off the interest and principal obligations of the existing or defeased bonds.

Corporate bond indentures often contain defeasance provisions which allow a company that previously issued a bond to deliver an escrow account with Treasury securities to the bond trustee. This account is pledged as collateral to guarantee the interest payments and principal repayment on the debt security. The interest and principal payments from the Treasury debt closely match the interest and principal obligations to be paid on the outstanding bond.

After the escrow account has been provided, the issuing company is no longer liable for servicing the debt. Instead, the Treasury escrow account becomes liable. A corporate issuer will often defease its existing securities when it would like to retire its debt but does not have an optional redemption clause on the bonds.