Reasonably Required Reserve Funds: Size Limits and Unrestricted Yield

A reserve fund can invest at unrestricted yield only up to the amount the federal arbitrage rules treat as reasonably required, and that amount is the least of 10 percent of the issue's stated principal, its maximum annual principal and interest requirements, and 125 percent of its average annual principal and interest requirements.

This page sits inside the federal arbitrage rules that limit what bond proceeds can earn, and it takes the size question for a debt service reserve fund or any other reserve or replacement fund.

The MSRB glossary describes a debt service reserve fund as a fund used to pay debt service if pledged revenues fall short, notes that its requirement is often a fixed percent of par or of maximum annual debt service, and states that the size and investment of the fund generally are subject to arbitrage regulations.

The same glossary lists the funding forms a reserve can take: bond proceeds, accumulated revenues, a surety policy, or funding only when a trigger occurs, which is called a springing reserve.

How the required balance is set is a question the debt service reserve fund page takes up; this page covers the federal tax limits that decide how much of the fund may be invested at unrestricted yield.

What is the three-pronged limit on a reasonably required reserve fund?

Treasury Regulation §1.148-2(f)(2)(ii) provides that the gross proceeds that can be treated as a reasonably required reserve or replacement fund may not exceed an amount equal to the least of 10 percent of the stated principal amount of the issue, the maximum annual principal and interest requirements on the issue, or 125 percent of the average annual principal and interest requirements.

Section 148(d)(2) of the Internal Revenue Code, restated at §1.148-2(f)(1), draws that outer line separately from the size test: an issue consists of arbitrage bonds if sale proceeds of the issue in excess of 10 percent of the stated principal amount are used to finance any reserve or replacement fund, whatever the yield on that fund.

Where an issue has more than de minimis original issue discount or premium, the statutory test is measured on the issue price, net of pre-issuance accrued interest, in place of stated principal.

The statutory test reaches sale proceeds only, so it does not restrict funding a reserve from accumulated revenues or from other sources outside sale proceeds.

Section 148(d)(2) does allow a higher amount if the issuer establishes the reserve requirement to the satisfaction of the Secretary, and §1.148-2(f)(3) preserves a narrow grandfather for parity reserves under master indentures in effect before August 16, 1986.

When one reserve secures more than one issue, as with a parity reserve fund, §1.148-2(f)(2)(ii) allows the limit to be measured on an aggregate basis.

The definition of the fund itself is broad: Treas. Reg. §1.148-1(c)(2) defines a sinking fund to include a debt service fund, redemption fund, reserve fund, replacement fund or any similar fund, to the extent reasonably expected to be used directly or indirectly to pay principal or interest on the issue.

The higher-yield treatment is also a right an issuer can give up: on or before the issue date, §1.148-2(h) lets an issuer elect to waive the right to invest in higher yielding investments as part of a reasonably required reserve fund, and whether a waiver serves an issue is a question for bond counsel.

What happens to amounts above the reasonably required level?

Treasury Regulation §1.148-2(f)(2)(i) provides that amounts above the reasonably required level are not part of the reserve or replacement fund.

The temporary periods that can reach such amounts are short: Treas. Reg. §1.148-2(e)(5)(ii) generally gives replacement proceeds other than a bona fide debt service fund 30 days from the date they first become replacement proceeds, and §1.148-2(e)(7) gives gross proceeds not otherwise eligible for a temporary period 30 days.

Once yield restriction applies, the general rule in §1.148-2(d)(2)(i) treats an investment yield as materially higher than the bond yield when it exceeds the bond yield by more than one-eighth of 1 percentage point, while §1.148-2(d)(2)(ii) sets that margin at one-thousandth of 1 percentage point for investments allocable to replacement proceeds.

At that point the yield restriction rules of section 148(a) cap the yield the excess may earn, unless a yield reduction payment is available.

For a reserve or replacement fund specifically, Treas. Reg. §1.148-5(c)(3)(v)(A)-(B) makes yield reduction payments available only where the value of the nonpurpose investments in the fund is not greater than 15 percent of the stated principal amount of the issue, or the fund is not expected to pay debt service except as the required balance declines.

The funding forms matter here too, because the statutory test limits only sale proceeds: a reserve built from accumulated revenues, backed by a surety policy, or funded only on a trigger does not put sale proceeds above the §1.148-2(f)(1) line.

The boundary also feeds the capital project tests: Treas. Reg. §1.148-1(b) defines net sale proceeds as sale proceeds less the portion invested in a reasonably required reserve or replacement fund under section 148(d) and less the minor portion, and the expenditure test and the time test for the 3-year capital project temporary period are measured on net sale proceeds.

The construction exception carries the same carve-out: 26 U.S.C. 148(f)(4)(C)(vi) reduces available construction proceeds by the amount of the issue price placed in a reasonably required reserve fund, which the 2-year construction exception page works through.

Inside the limit, the size rules settle yield restriction only, not rebate: IRS Publication 5271 notes that "the yield restriction rules may allow the issuer to earn the arbitrage, but the rebate rules may not allow the issuer to keep the arbitrage," so reserve fund earnings generally remain subject to the rebate rules of section 148(f).

IRS Publication 4079 states the same layering for small issuers: the small issuer exception is an exception from rebate and not from the arbitrage rules altogether, the yield restriction rules still apply, and an issuer using it must still show that any reserve fund is reasonably required.

Whether amounts held for the bonds count as proceeds at all has its own definition: the SEC's municipal advisor rules define proceeds of municipal securities to include sale proceeds, investment income, and pledged funds such as reserves and sinking funds held under the bond documents, which stop being proceeds when spent on the authorized purposes.

That SEC definition is separate from the tax definitions in Treas. Reg. §1.148-1, and the tax treatment of pledged and replacement amounts is taken up on the replacement proceeds page.

What does the size limit mean for reserve investment strategy?

The arbitrage rules shape reserve investment strategy less by naming investments than by fixing how much may earn above the bond yield, how long the money stays, and what the earnings still owe.

On duration, GFOA treats the debt service reserve fund as the long-term fund among bond proceeds funds, against a typical 12 to 36 months for a construction fund, 6 to 18 months for a capitalized interest fund, usually 6 months for an interest account and usually 12 months for a principal account, and GFOA presents these as typical ranges rather than rules.

Structures exist for that long horizon: the MSRB glossary notes that a forward may provide for the delivery of specific types of securities on specified future dates at fixed yields, a use it describes as optimizing the investment of a debt service reserve fund, and the forward delivery agreement page covers the structure.

For yield-restricted holdings, 31 CFR 344.1 limits purchases of State and Local Government Series securities to an eligible source of funds, a list that includes gross proceeds of tax-advantaged bonds and amounts held with them in a refunding escrow, defeasance escrow, parity debt service reserve fund or commingled fund.

Whether a particular reserve is an eligible source of funds under that regulation is a question for bond counsel, and the SLGS page explains the program.

The SLGS window is also conditional: 31 CFR 344.2(l) reserves Treasury's right to change or suspend the offering whenever the Secretary determines that issuing obligations sufficient for the orderly financing operations of the United States cannot be made without exceeding the statutory debt limit, during which unredeemed Demand Deposits may be moved into special 90-day certificates of indebtedness.

When does the size question come up again?

The size question is not settled once at closing: it comes back when a drawn fund is replenished, when a reserve comes to secure additional issues, when a refunding moves amounts between issues, and when older investments are reviewed.

After a draw reduces the balance, restoring it from accumulated revenues is one of the funding forms the MSRB glossary lists, and the debt service reserve fund page takes up the valuation and replenishment terms behind that.

Adding a second issue to a parity reserve changes the measurement, because §1.148-2(f)(2)(ii) allows the limit for a reserve securing more than one issue to be measured on an aggregate basis.

A refunding raises the question again, because Treas. Reg. §1.148-9 defines transferred proceeds as proceeds of a refunded issue that become proceeds of the refunding issue, and the refundings page introduces the types.

Older agreements carry their own review question: U.S. dollar LIBOR panels ended after June 30, 2023, and under the LIBOR Act the Federal Reserve Board adopted SOFR-based replacement rates on December 16, 2022 for tough legacy contracts without workable fallbacks, covering overnight, 1-month, 3-month, 6-month and 12-month LIBOR.

How a particular investment agreement moved off LIBOR depends on its fallback language, and mGIC can check your proceeds against the rules as part of a no-obligation review of an existing reserve investment.

mGIC is an independent, SEC-registered municipal advisor and Bidding Agent that helps issuers structure, competitively bid and close investments of bond proceeds, including reserve funds; it sells no investment product, does not act as principal in the investments it evaluates, and is paid by the winning provider rather than the issuer.

To start that conversation, contact mGIC for a free, no-obligation reinvestment review.

Whether a particular reserve fund satisfies the size rules, and how the fund should be invested for a specific issue, are conclusions for the issuer's bond counsel and tax counsel.

Last updated 2026-10-06.

This page is general educational information about municipal finance and federal and state rules as of the date shown. It is not legal, tax or investment advice, and it is not a recommendation about any particular investment. Product availability, legality and suitability depend on the issuer, jurisdiction, governing documents and transaction-specific facts. Final legal and tax determinations remain with the issuer's bond counsel, tax counsel and other advisors.