THE SHORT ANSWER
A debt service reserve fund is typically invested for the long term, because it is spent only when pledged revenues fall short. A reasonably required reserve fund may invest at unrestricted yield up to the least of 10 percent of stated principal, the maximum annual principal and interest requirements and 125 percent of the average annual principal and interest requirements. The excess is not part of the fund; section 148(a)'s yield restriction rules apply.
A debt service reserve fund is not spent on a schedule, so it is invested for the long term and, within the federal size limit, may be invested at a yield above the bond's own.
Two documents set its shape: the indenture and its flow of funds fix the required balance, and Internal Revenue Code section 148(d) and Treasury Regulation 1.148-2(f) cap the amount that can be treated as a reasonably required reserve or replacement fund.
Among the funds that hold bond proceeds, the reserve fund is sized to the bonds rather than to a project or a spending calendar, which is what separates its investment problem from a construction fund's.
What a debt service reserve fund is and when it can be drawn
A debt service reserve fund holds money set aside to pay debt service if pledged revenues fall short of the amount due, as the MSRB glossary describes the fund in its flow-of-funds materials.
The requirement behind it is often set as a fixed percent of par or of maximum annual debt service, and the MSRB glossary notes that the size and investment of the fund are generally subject to arbitrage regulations.
The fund is drawn when pledged revenues cannot cover the debt service due on the bonds; how a draw and its replenishment are handled is an indenture question, taken up below.
The MSRB glossary lists the ways a fund can be built: it may be funded with bond proceeds, with accumulated revenues, with a surety policy, or only on a trigger, which is called a springing reserve.
GFOA's guidance on the investment and management of bond proceeds treats the debt service reserve fund as the fund with a long-term investment horizon, against construction funds at a typical 12 to 36 months and capitalized interest funds at a typical 6 to 18 months.
GFOA presents those horizons as typical ranges that vary with expectations, and points issuers to their advisory team and investment policy.
The reasonably required reserve fund size limit
The amount of gross proceeds that can be treated as a reasonably required reserve or replacement fund cannot exceed the least of 10 percent of the stated principal amount of the issue, the maximum annual principal and interest requirements, and 125 percent of the average annual principal and interest requirements, under Treasury Regulation 1.148-2(f)(2)(ii).
Section 148(d)(2) of the Internal Revenue Code adds a ceiling with a different trigger: an issue consists of arbitrage bonds if sale proceeds above 10 percent of the stated principal amount finance any reserve or replacement fund, whatever the yield on that fund, a rule Treasury Regulation 1.148-2(f)(1) restates.
If the issue has more than de minimis original issue discount or premium, that statutory test is measured on the issue price, net of pre-issuance accrued interest, instead of stated principal.
The statute allows a higher reserve amount if the issuer establishes it to the Secretary's satisfaction, and Treasury Regulation 1.148-2(f)(3) grandfathers a narrow category of parity reserves under master indentures in place before August 16, 1986.
Funding a reserve from sources other than sale proceeds, such as accumulated revenues, is not restricted by that 10 percent sale-proceeds test.
For a reserve that secures more than one issue, such as a parity reserve fund, the limit may be measured on an aggregate basis under 1.148-2(f)(2)(ii).
Amounts above the reasonably required level are not part of the reserve fund at all under Treasury Regulation 1.148-2(f)(2)(i), which is the hinge for the yield restriction discussion below.
| Prong | Amount | Where the rule is |
|---|---|---|
| Principal cap | 10 percent of the stated principal amount of the issue | Treas. Reg. 1.148-2(f)(2)(ii) |
| Debt service cap | Maximum annual principal and interest requirements | Treas. Reg. 1.148-2(f)(2)(ii) |
| Average cap | 125 percent of average annual principal and interest requirements | Treas. Reg. 1.148-2(f)(2)(ii) |
| Binding limit | The least of the three | Treas. Reg. 1.148-2(f)(2)(ii) |
The carve-out reaches further than the fund itself, because Treasury Regulation 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, so the reserve's size feeds the spending tests built on net sale proceeds.
It also feeds the construction spending exception, because 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.
The reasonably required reserve fund page works through the measurement questions in detail.
Why long-term fixed-rate agreements fit reserves
GFOA's long-term horizon for the reserve fund is the starting point, because the money can be needed at any debt service date over the life of the bonds, while GFOA treats a construction fund's horizon as short-term.
The MSRB glossary's entry on forward contracts describes one structure aimed at this fund: a forward can provide for the delivery of specific types of securities on specified future dates at fixed yields "for the purpose of optimizing the investment of a debt service reserve fund."
The fixed-rate alternative is covered on the long-term GIC for reserves page.
State law can also set outer boundaries on term, and the statutes differ.
Texas Government Code 2256.015(b) says bond proceeds "may not be invested under this subchapter in a guaranteed investment contract with a term of longer than five years from the date of issuance of the bonds," and it excepts proceeds that are reserves and funds maintained for debt service purposes.
The Texas clock runs from the bond issue date rather than the date of the GIC, and whether a particular reserve investment agreement satisfies the state's statute is a determination for bond counsel.
Ohio Revised Code 135.14(D) generally requires investments made under that section to mature within five years from the date of settlement, "unless the investment is matched to a specific obligation or debt of the subdivision."
Whether a reserve investment is matched to a specific obligation or debt of the subdivision within the meaning of that exception is a question for bond counsel under the state statute.
On the federal side, 31 CFR 344.1 treats amounts held with gross proceeds in a refunding escrow, defeasance escrow, parity debt service reserve fund or commingled fund as an eligible source of funds for buying State and Local Government Series (SLGS) securities, and the SLGS page explains the program.
Whether a particular reserve is an eligible source of funds under that regulation is a question for bond counsel.
Where a cash-funded reserve is to be bid at closing, a Bidding Agent can prepare the bid specifications, solicit qualified providers, manage provider questions and compare the bids on rate and non-rate terms, and mGIC performs that role as an independent municipal advisor that does not sell the products it bids.
Valuation and replenishment provisions in the indenture
The reserve requirement, the investments that count toward it, the valuation of fund investments against the requirement, and the replenishment of the fund after a draw are terms of the indenture and its flow of funds.
The MSRB glossary describes the requirement as often a fixed percent of par or of maximum annual debt service, set in the deal's flow of funds.
How the value of the investments is determined for that test is the subject of the indenture's valuation provisions, covered on the indenture valuation provisions page, and the bond indenture page covers the document itself.
After a draw reduces the balance, restoring the fund is one of those indenture terms, and the MSRB glossary lists accumulated revenues among the ways a reserve can be funded.
However the indenture words these sections, the federal limits above still cap the part of the fund that can invest at unrestricted yield, and what a specific indenture permits for a specific issue is a conclusion for bond counsel.
Yield restriction on the excess over the limit
Amounts above the reasonably required level are not part of the reserve fund under Treasury Regulation 1.148-2(f)(2)(i), so they do not share the fund's unrestricted-yield treatment, and the yield restriction rules of Internal Revenue Code section 148(a) apply to them.
Inside the limit, the fund's status answers the yield question only in part, because the earnings of a reserve fund are generally still subject to the rebate rules even though the fund itself may invest at unrestricted yield.
IRS Publication 4079 makes the same layering explicit for small issuers: the small issuer exception is an exception from rebate and not from the arbitrage rules altogether, and an issuer using it still needs a temporary period for project funds and must show any reserve fund is reasonably required.
Where a reserve fund is held above the bond yield, 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.
Another lever sits at closing: under Treasury Regulation 1.148-2(h) an issuer may elect on or before the issue date to waive the right to invest in higher yielding investments as part of a reasonably required reserve fund, and it may waive the minor portion at any time.
| Mechanism | What the rule provides | Where the rule is |
|---|---|---|
| Yield restriction on the excess | Amounts above the reasonably required level are not part of the fund | Treas. Reg. 1.148-2(f)(2)(i) |
| Yield reduction payments | Available for reserve funds only within the stated limits | Treas. Reg. 1.148-5(c)(3)(v)(A)-(B) |
| Waiver election | Issuer may waive higher-yield investing for the reserve on or before the issue date | Treas. Reg. 1.148-2(h) |
| Rebate | Reserve fund earnings are generally still subject to rebate, even where investing above the bond yield is allowed | Section 148(f); IRS Publication 4079 |
Whether to make the waiver election, and how to treat the fund's excess, are determinations for bond counsel and tax counsel rather than investment decisions alone.
Reserve fund surety policies vs cash-funded reserves
A reserve does not have to be cash: the MSRB glossary lists bond proceeds, accumulated revenues, a surety policy and a trigger-funded springing reserve as the funding forms a debt service reserve fund can take.
| Funding form | What it means for the invested balance |
|---|---|
| Bond proceeds at closing | Sale proceeds fund the reserve, counted against the 10 percent sale-proceeds ceiling of Treas. Reg. 1.148-2(f)(1) |
| Accumulated revenues | Funded from revenues rather than sale proceeds, so the 10 percent sale-proceeds test does not restrict the funding |
| Surety policy | The requirement is met with the policy rather than a cash deposit of proceeds, so the policy itself adds no cash to invest |
| Springing reserve | Funded only when a trigger occurs, so that funding form supplies no reserve cash to invest before the trigger |
With a surety policy, the requirement is met by the policy rather than by a cash deposit of proceeds, so the policy itself adds no reserve cash to invest.
A springing reserve is funded only when its trigger occurs, so there is nothing to invest until that point.
For the investment question, the funding form decides first how much cash there is to invest at all.
Where a reserve is cash-funded and to be invested at closing, a Bidding Agent can structure the investment terms, solicit qualified providers and compare bids on rate and non-rate terms, and mGIC performs that role as an independent municipal advisor paid by the winning provider rather than the issuer.
mGIC also reviews existing reserve investments through a free, no-obligation reinvestment review, and the contact page is the place to start that conversation or sign up for the daily rate-update emails.
Sizing the fund, matching a state statute and resolving the tax treatment of any excess are conclusions for bond counsel and tax counsel, and the investment structuring around those conclusions is where an independent Bidding Agent and reinvestment advisor fits.
Frequently asked questions
Are debt service reserve fund earnings exempt from arbitrage rebate?
No. Being reasonably required lets the fund invest at unrestricted yield up to the limit in Treasury Regulation 1.148-2(f)(2)(ii), but the earnings are generally still subject to the rebate rules, as IRS Publication 4079's discussion of the spending exceptions reflects.
What is a springing debt service reserve fund?
The MSRB glossary lists a trigger-funded reserve, called a springing reserve, among the ways a debt service reserve fund can be funded. Until the trigger occurs, that funding form supplies no reserve cash to invest.
Do state laws limit the term of a reserve fund GIC?
Some do. Texas Government Code 2256.015(b) caps GIC terms at five years from the bond issue date but excepts reserves and funds maintained for debt service purposes, and Ohio Revised Code 135.14(D) generally requires investments to mature within five years of settlement unless matched to a specific obligation or debt of the subdivision. Bond counsel applies the applicable state statute to the specific fund.
Can an issuer waive higher-yield investing in its reserve fund?
Yes. Treasury Regulation 1.148-2(h) lets an issuer elect on or before the issue date to waive the right to invest in higher yielding investments as part of a reasonably required reserve fund, and to waive the minor portion at any time.
How is the reserve limit measured for a parity reserve fund?
For a reserve securing more than one issue, such as a parity reserve fund, Treasury Regulation 1.148-2(f)(2)(ii) allows the limit to be measured on an aggregate basis.
Sources
- MSRB Glossary of Municipal Securities Terms (2013)
- GFOA, Investment and Management of Bond Proceeds (approved Mar. 4, 2022)
- 26 CFR 1.148-2, General arbitrage yield restriction rules
- 26 CFR 1.148-1, Definitions
- 26 U.S. Code 148, Arbitrage
- 31 CFR 344.1, SLGS eligible source of funds
- Texas Government Code 2256.015(b)
- Ohio Revised Code 135.14(D)
- IRS Publication 4079, Tax-Exempt Governmental Bonds (Rev. 9-2019)
- IRS Publication 5271, Complying with Arbitrage Requirements (Rev. 9-2019)
- 26 CFR 1.148-5, Yield and valuation of investments
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.
