What it means
When an issuer defeases a bond, it places cash or government securities in an irrevocable trust, meaning one that cannot be undone or raided. The trustee pays the bondholders from that pool as payments fall due.
Investors holding the bonds therefore look to the trust, not to the issuer, for repayment. Issuers do this for several reasons.
They may want to remove restrictive covenants (promises in the bond agreement, such as limits on further borrowing), clear the way for a sale of assets, or retire debt that cannot yet be called. Governments and municipalities have often used the technique after refinancing at lower rates.
For investors, the credit quality of defeased bonds is typically very high, since the trust holds government securities. Rating agencies have commonly upgraded such bonds to the top rating after the trust is established.
The bonds usually trade at prices that reflect the safe assets and the remaining time to maturity, not the issuer's former credit standing. On the accounting side, treatment depends on the standards being applied and on whether the defeasance is legal or in-substance.
In a legal defeasance the debtor is formally released, so the debt can leave the balance sheet. In-substance arrangements, where the debtor is not formally released, are treated far more cautiously than they once were, and finance teams should confirm the current rules with their auditors.
The key number to monitor is whether the trust assets are sufficient. If the trust is too small, or the securities mature too late, there is a shortfall, and the trustee or issuer may need to top it up.
Independent verification of the cash flows is therefore standard, and an accounting firm will often issue a report confirming that the payments match.
In practice
Real-world examples.
Example
A city refinances a hospital bond at a lower rate but cannot call the old bonds for four years. It buys government securities, places them in trust, and the old bonds are now defeased until their call date. Residents benefit because the lower-cost debt now funds the hospital, while the old bondholders are paid from the trust.
Example
A manufacturer wants to sell a division that is pledged under an older bond agreement. By defeasing the bonds, it removes the covenant restricting the sale and completes the transaction.
Example
A pension fund manager holds defeased bonds from a former utility issuer. The portfolio team treats them as near government-risk holdings, and the yield sits well below the issuer's earlier trading level. The manager keeps them because the payment dates line up neatly with benefits the fund must pay in the next few years.
Formula
Calculation
Coverage ratio = value of trust assets / present value of remaining debt payments
Remaining debt payments are the interest and principal still owed on the defeased bonds, discounted to today.
A city has defeased bonds whose remaining payments have a present value of $10,000,000. It places government securities worth $10,400,000 in the trust. Coverage ratio = $10,400,000 / $10,000,000 = 1.04. The trust has 4% more than it needs, which is a cushion of $400,000.Case study
Seen in the real world.
Brightwater Utilities District is an illustrative, fictional issuer. It had $25,000,000 of older bonds with a covenant that prevented it from selling a treatment plant.
The finance director calculated that government securities costing $25,900,000 would meet every remaining payment. After the sale proceeds were received, the district funded the trust, and the bonds were defeased. The covenant fell away, and the sale of the plant went ahead.
Because Brightwater is a made-up example, the figures are for teaching only. The director later explained to the board that the $900,000 premium was a real cost, but it was smaller than the gain from selling the plant. The board asked that every future defeasance be accompanied by a one-page comparison with simply waiting for the call date.
Watch out
Common mistakes.
- Treating defeased bonds as if they carry the issuer's original credit risk, when repayment now depends on the trust assets.
- Assuming defeasance always removes debt from the balance sheet, when the answer depends on the accounting standard and the type of defeasance.
- Ignoring the cost of the trust, which often exceeds the face value of the debt when market rates are low.
Questions
People also ask.
Are defeased securities completely risk free?
They are very low risk, but there remains a small chance of trust shortfall, trustee error or mismatch of cash flows, so investors still read the trust documents.
Why would an investor buy them?
They offer a predictable income stream with very strong credit quality, which suits investors who need certainty.
Can defeased bonds be called early?
It depends on the bond terms, but often the trust is set up to redeem the bonds at the first permitted call date, which is then treated as their effective maturity.
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