Yield Burning in Municipal Escrows: What It Is and Why Safe Harbors Exist

Yield burning in a municipal escrow is the sale of securities to an issuer at above-market prices so the escrow's yield comes in low enough to avoid the federal arbitrage rules, a practice the SEC has called illegal.

The practice sits where escrow pricing and tax law meet, and the regulatory answer to it is the competitive bidding process behind the fair market value safe harbor.

What is yield burning?

The MSRB glossary defines yield burning as "the sale to an issuer of securities (typically Treasury securities) at above-market prices to be held in escrow for the purpose of reducing the yield on those securities to avoid arbitrage regulations."

The MSRB notes that the SEC and IRS view the practice as illegal.

The SEC described the mechanics in its April 2000 order in the Hough matter, an advance refunding case: dealers overcharging for open-market escrow securities in a positive-arbitrage situation divert tax arbitrage to the dealers at the expense of the U.S. Treasury.

The same order noted that underpricing a forward supply contract in a positive-arbitrage situation is yield burning as well.

The setting is an advance refunding, where the refunding issue's proceeds sit in a refunding escrow of securities until the refunded bonds are redeemed.

Price is the lever because escrow yield is capped so tightly: under Treasury Regulation 1.148-2(d)(2)(ii), "materially higher" than the bond yield means one-thousandth of 1 percentage point for investments in a refunding escrow or for investments allocable to replacement proceeds.

Paying more than the market price for the same stream of principal and interest mechanically lowers the yield that stream produces, which is why an inflated purchase price does the work.

Lawful ways to hold escrow yield down

The Hough order also noted lawful ways to limit an escrow's yield, such as buying SLGS or buying shorter open-market securities and following them with zero-interest SLGS.

The valuation rule makes the direct-purchase route different in kind: under Treasury Regulation 1.148-5(d)(6)(i), the fair market value of a Treasury obligation bought directly from the Treasury, including a State and Local Government Series security, is its purchase price on the purchase date, and on other dates a SLGS is valued at its redemption price for that date.

Whether an escrow should hold SLGS or open-market securities is its own comparison, covered in SLGS or open-market Treasuries for a refunding escrow.

What the 2017 tax law changed

The classic setting narrowed after section 13532 of Public Law 115-97 (December 22, 2017) amended the code: 26 U.S.C. 149(d)(1) provides that nothing in section 103(a) or any other law exempts from federal income tax the interest on any bond issued to advance refund another bond.

The statute treats a bond as issued to advance refund another bond when it is issued more than 90 days before the refunded bond is redeemed, and the repeal applies to advance refunding bonds issued after December 31, 2017.

Taxable advance refundings and current refundings remain possible; what ended is the federal tax exemption for the new advance refunding bonds.

Pre-2018 tax-exempt advance refunding escrows still outstanding remain subject to the arbitrage rules, so the escrow pricing questions this page describes did not disappear with the repeal.

When did the SEC act against yield burning?

On April 6, 2000, the SEC announced 10 actions against 10 entities and one individual for fraud and other securities violations in connection with a series of refunding bond offerings.

The SEC's Hough order cited the Ninth Circuit's decision in Harbor Bancorp & Subsidiaries v. Commissioner, 115 F.3d 722 (9th Cir. 1997).

One of the 10 actions was a settlement with Dain Rauscher, which agreed to pay about $13 million to the U.S. Treasury and certain issuers to settle yield-burning claims.

The settlement included $10,586,081.59 to the U.S. Treasury for positive-arbitrage escrow sales, $1,607,623.38 to certain issuers for negative-arbitrage refundings, and disgorgement and interest of $647,487 plus a $100,000 civil penalty for an Arizona COPs transaction.

The breakdown shows both sides of the harm: the U.S. Treasury portion covered the positive-arbitrage escrow sales, while the issuer portion covered the negative-arbitrage refundings.

Dain Rauscher settled without admitting or denying the findings, and the U.S. Attorney for the Southern District of New York settled a related False Claims Act suit.

The Hough order also noted that the IRS can declare interest on the refunding bonds taxable.

Another enforcement wave arrived a decade later, and it aimed past the price of escrow securities at the integrity of the bidding itself.

How does competitive bidding prevent yield burning?

The regulations answer the pricing problem with process: Treasury Regulation 1.148-5(d)(6)(i) defines fair market value as the price a willing buyer would pay a willing seller in a bona fide arm's-length transaction, generally on the trade date, and rebuttably presumes that an investment not of a type traded on an established securities market is not bought or sold at fair market value.

That presumption is why guaranteed investment contracts and escrow portfolios depend on the bidding safe harbor.

Treasury Regulation 1.148-5(d)(6)(iii) treats the purchase price of a guaranteed investment contract, and of an investment purchased for a yield-restricted defeasance escrow, as the fair market value of the investment on the purchase date when all of its requirements are satisfied: a bona fide solicitation, qualifying bids, winning-bid rules, a provider certification, and record retention.

Each of those requirements is detailed in the fair market value safe harbor guide.

The safe harbor is a presumption rule, not a conclusion: falling short of its requirements costs the issuer the treated-as-fair-market-value presumption, and does not automatically mean the price was not fair market value.

What the process produces is a price set by competing bids rather than one quoted by the counterparty on the other side of the trade, and the provider certification under Treasury Regulation 1.148-5(d)(6)(iii)(D) covers the administrative costs the provider pays or expects to pay to third parties in connection with supplying the investment, while the rule also requires record retention.

That protection holds only if the solicitation is genuine, which the SEC's 2010 to 2011 enforcement wave demonstrated from the negative side.

The SEC described two techniques in the Wachovia release: a "last look," where a provider received competing-bid information from the bidding agent, and a "set-up," where the bidding agent deliberately obtained non-winning bids from other providers.

The SEC also described undisclosed payments flowing to bidding agents: gratuitous payments and kickbacks in the Banc of America case, payments routed through interest rate swaps in the UBS case, and inflated or unearned swap fees in the GE Funding case.

In the Banc of America and Wachovia matters, the SEC described the products as guaranteed investment contracts, repurchase agreements and forward purchase agreements.

Five of the settlements the SEC announced in that wave:

Each firm settled without admitting or denying the SEC's findings.

As of December 23, 2011, the SEC said more than $743 million had been recovered from financial institutions in these settlements and that 18 individuals had been indicted or had pled guilty.

The SEC also said the corrupted bidding deprived municipalities of a conclusive presumption that reinvestment instruments were purchased at fair market value, and its litigation release in the Wachovia matter said the bidding corruption jeopardized the tax-exempt status of billions of dollars in municipal securities.

From the issuer's side, GFOA's best practice on bond proceeds recommends an investment policy with specific provisions for bond proceeds that ensure legal and regulatory requirements are met, fair market value bids are received when required by tax law and state or local laws, and issuer objectives are attained.

What such a policy should contain is covered in the bond-proceeds investment policy guide.

mGIC works on the issuer's side of this process as an independent Bidding Agent: it prepares bid specifications, solicits qualified providers, manages questions, and receives and compares bids on rate and non-rate terms, then coordinates documentation and delivers the Bidding Agent and provider certifications to bond counsel.

mGIC sells no investment product and does not act as principal, and its fee is paid by the winning provider rather than the issuer, at or below the safe-harbor maximum in the Treasury arbitrage regulations, with the fee disclosed.

For an escrow or reinvestment already in place, mGIC can check your proceeds against the rules as part of a free, no-obligation review, which you can start on the contact page.

How is yield burning different from negative arbitrage?

Yield burning is a practice, overcharging an issuer for escrow securities; negative arbitrage is an earnings condition, invested proceeds earning less than the bond yield they are measured against.

The statute anchors the line from the positive side: under 26 U.S.C. 148(a), a bond is an arbitrage bond if any part of an issue's proceeds is reasonably expected at issuance, or intentionally used, to acquire higher yielding investments or to replace funds used to acquire them.

In an escrow the practice and the condition meet: in a positive-arbitrage escrow the SEC said a dealer's overcharge diverts tax arbitrage to the dealer at the U.S. Treasury's expense, and in a negative-arbitrage escrow it said the same overcharge reduces the issuer's advance refunding savings dollar for dollar.

That order described advance refundings as they operated before 2018, when tax-exempt advance refundings were still being issued, and the negative arbitrage page covers the condition's cost and the levers for reducing it on their own.

Whether an escrow sits on the positive or the negative side, and what an above-market price did to it, are determinations for 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.