What Is a Prefunded Bond and How Does It Work?

Governments and municipalities issue bonds to raise funds, but they sometimes refinance their debt before maturity. One method is through a prefunded bond, which ensures investors continue receiving payments while the issuer prepares for early redemption.

This type of bond provides security because it is backed by low-risk assets until the original bond is retired. Understanding how they function helps investors assess their safety, tax implications, and potential returns.

Escrow Setup for Prefunding

To ensure repayment, issuers establish an escrow account holding secure assets until the original debt is retired. A third-party trustee manages this account, ensuring funds are used solely for debt repayment. The most common assets placed in escrow are U.S. Treasury securities, which provide a predictable income stream and are backed by the federal government. This structure eliminates default risk, making prefunded bonds highly reliable.

The escrow account generates enough income to cover interest payments until the bond’s call date or maturity. Treasury bonds or Treasury STRIPS are commonly used because their principal and interest payments align with the bond’s debt service requirements. Some issuers use State and Local Government Series (SLGS) securities instead of marketable Treasuries. Issued by the U.S. Treasury for municipal bond escrows, SLGS allow issuers to match cash flows while complying with federal arbitrage regulations. These rules, enforced by the IRS under Section 148 of the Internal Revenue Code, prevent issuers from profiting by investing borrowed funds at higher yields than their borrowing costs.

Steps in Redeeming the Original Bond

Once funds are set aside, the issuer identifies the earliest redemption date. Many municipal and government bonds include call provisions allowing early redemption, typically after a set number of years. The issuer must notify bondholders in advance, usually 30 to 60 days before redemption, as specified in the bond’s official statement. This notice gives investors time to prepare and reinvest proceeds.

On the redemption date, the trustee overseeing the escrow account disburses funds to bondholders through the Depository Trust Company (DTC), the central clearinghouse for most U.S. securities. Investors receive the principal amount along with any accrued interest.

If the bond includes a call premium, the issuer must pay an additional percentage over the face value to compensate investors for early redemption. Call premiums typically range from 1% to 3% of the bond’s par value, depending on the terms set at issuance. This offsets reinvestment risk if interest rates have declined.

Rating Considerations

Credit rating agencies evaluate prefunded bonds differently than traditional municipal or corporate debt. Since these bonds are backed by escrowed securities rather than the issuer’s creditworthiness, their ratings depend on the quality of the assets in escrow. If the escrow consists of U.S. Treasury securities or SLGS bonds, the prefunded bond often receives a rating equivalent to the U.S. government’s credit rating, which as of 2024 is AA+ from S&P and Aaa from Moody’s. This makes them more secure than the original bond, which depended on the issuer’s financial health.

Rating agencies also review the legal structure of the escrow arrangement to confirm that funds are irrevocably dedicated to bond repayment. A properly structured escrow agreement includes a defeasance clause, which legally removes the original bond from the issuer’s balance sheet. If this clause is missing or improperly executed, agencies may assign a lower rating due to potential legal disputes. Auditors and legal counsel must also certify that escrowed securities generate sufficient cash flow to cover all scheduled payments. Even a minor shortfall can prevent the prefunded bond from achieving the highest rating.

Investors also consider the call provisions of the original bond. If the issuer has the option to redeem the bond early but delays doing so, investors may be exposed to lower-yielding securities for longer than expected. While this does not affect the bond’s credit rating, it influences pricing in the secondary market. Prefunded bonds trading at a premium may see price declines if the call date is further away, as investors adjust for lower reinvestment opportunities.

Tax Treatment for Investors

The tax implications of prefunded bonds depend on whether they were originally issued as tax-exempt municipal bonds or taxable securities. If a tax-exempt municipal bond is prefunded, its tax status generally remains unchanged, allowing investors to continue receiving interest payments free from federal income tax. However, state and local tax treatment varies. Some states exempt interest from in-state municipal bonds while taxing out-of-state issues, which can affect an investor’s after-tax yield.

For taxable prefunded bonds, interest income is subject to federal and, in many cases, state and local taxation. Investors must report this income on their tax returns, typically using IRS Form 1099-INT. High-income investors should also consider the 3.8% Net Investment Income Tax (NIIT), which applies to certain passive income sources, including taxable bond interest, if their modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for joint filers.

Returns and Liquidity

Investors evaluating prefunded bonds must consider expected returns and liquidity in the secondary market. Since these bonds are backed by escrowed assets with predictable cash flows, they typically offer lower yields than comparable non-prefunded municipal or corporate bonds. The trade-off is reduced credit risk, as repayment funds are already set aside. Investors seeking stability may accept these lower yields, particularly during periods of economic uncertainty.

Liquidity depends on factors such as the bond’s call date, coupon structure, and prevailing interest rates. Prefunded bonds with shorter durations tend to be more liquid, as institutional investors and mutual funds often seek them for short-term portfolio adjustments. However, if interest rates rise significantly after the bond is prefunded, its price may decline, making it less attractive to buyers. Conversely, in a falling rate environment, these bonds can trade at a premium, though investors must weigh the reinvestment risk if the bond is called earlier than expected.