How GIC Earnings Can Improve Pro-Forma Debt Service Coverage

A GIC's earnings can improve debt service coverage in two places: where the bond documents count investment earnings in the revenues available for debt service, and where capitalized interest pays debt service during construction so project revenues are not drawn on.

This page sets out the coverage definition those mechanics start from, where earnings enter a pro forma calculation, how a capitalized interest fund carries debt service, and the arithmetic on an illustrative issue.

What is the debt service coverage ratio?

The MSRB glossary defines coverage as the ratio of revenues available annually to pay debt service over the annual debt service requirement.

A result of 1.25, to take a round figure, means available revenues are 1.25 times the amount the debt service schedule requires that year.

The definition is a general one: indentures define "available revenues" differently, so which receipts enter the numerator is fixed by the issuer's own documents rather than by the glossary.

Where an indenture sets a minimum coverage level, the test runs against that level on the definitions the document itself supplies.

Pro forma coverage is the projected version of the same ratio: expected available revenues against scheduled debt service, measured on the same document definitions.

Investment earnings enter the picture because proceeds held in funds between draws can be invested, and the documents decide whether the earnings that produces counts.

Where do GIC earnings enter a pro forma coverage calculation?

Earnings enter where the bond documents put them: in the numerator, when investment earnings fall within the document's definition of available revenues, or on the payment side, when a fund such as capitalized interest pays debt service directly.

Where earnings are in the numerator, the earnings come from the issuer's investments, and a GIC supplies them on a contractual basis: the MSRB glossary defines a guaranteed investment contract as an investment, secured by a contract with a financial institution, that guarantees a fixed rate of return and a fixed maturity, so the amounts credited over the term are set by the agreement rather than by daily rate moves.

A GIC for a fund is bid against that fund's schedule rather than in the abstract: Treasury Regulation §1.148-5(d)(6)(iii)(A)(5) requires that, for purchases of guaranteed investment contracts, the terms of the solicitation take into account the issuer's reasonably expected deposit and drawdown schedule for the amounts to be invested.

On a tax-exempt issue, the federal arbitrage rules bound the earnings those contracts can carry: outside a temporary period or another exception, Treasury Regulation §1.148-2(d)(2)(i) treats the yield on an investment the rest of paragraph (d)(2) does not otherwise describe as materially higher than the bond yield when it exceeds the bond yield by more than one-eighth of 1 percentage point, the line yield restriction enforces.

Temporary periods set how long the yield restriction rules may allow proceeds to earn above the bond yield: proceeds reasonably expected to be allocated to working capital expenditures within 13 months after the issue date, for example, qualify for a 13-month temporary period beginning on the issue date under §1.148-2(e)(3)(i), and capitalized interest can be treated as part of a capital project in some cases, which is a determination for bond counsel.

Earning above the bond yield is not the same as keeping it: IRS Publication 5271 says that even when the yield restriction rules allow an issuer to invest above the bond yield, the rebate rules may require it to pay those arbitrage earnings to the U.S. Treasury.

What about the denominator?

Earnings work on the numerator, and the denominator is the annual debt service requirement set in the bond documents, which an investment does not change; where the requirement itself changes, that comes with a refunding rather than with an investment.

An escrow refunding brings its own roles: GFOA describes an escrow agent, typically a commercial bank, that holds the escrow investments, a verification agent, typically a CPA firm, that confirms the escrow is sufficient and that escrow yield stays within the permitted yield where it is limited, and an escrow bidding agent that solicits bids for open-market escrow securities, a role GFOA notes a municipal advisor, if engaged, may be able to fill.

Where an escrow buys open-market securities in a positive-arbitrage advance refunding, the SEC's findings in a settled enforcement order describe dealers overcharging for those securities and diverting tax arbitrage to themselves at the U.S. Treasury's expense, a practice the SEC called yield burning and illegal, and the SEC noted the IRS can declare interest on the refunding bonds taxable.

GFOA's typical investment horizons frame how long each fund's earnings run:

GFOA presents these as typical ranges rather than rules, says expectations vary, and points issuers to their advisory team and investment policy.

The fund guides take each fund's investing questions separately.

How does capitalized interest offset debt service during construction?

Capitalized interest is a portion of the proceeds of an issue set aside to pay interest on the securities for a specified period, in the MSRB glossary's definition, and it is commonly used during construction of a revenue-producing project so that debt service does not begin until the project is expected to be operating.

It is also called funded interest.

The offset runs through who pays: while the fund pays the interest coming due, the project's revenues are not drawn on for it, and earnings credited on the fund stretch the same mechanism, because interest the earnings pay is interest that does not have to come from bond principal or project revenues.

For illustration, say a capitalized interest fund must pay $4.0 million of scheduled interest over a construction period and the investment on it credits $0.3 million along the way: $3.7 million of bond principal would then cover the same $4.0 million of interest.

Investments whose maturities or withdrawals can be scheduled against interest payment dates line up with that window.

A GIC held against capitalized interest is one: in that use, the issuer's expected deposit and drawdown schedule for the fund is the schedule of interest payments in the illustration, which is what the §1.148-5(d)(6)(iii)(A)(5) solicitation condition requires the terms to reflect, and the mechanics of those withdrawal schedules are the subject of the GIC withdrawal provisions guide.

A portfolio of STRIPS is another: Treasury STRIPS split an eligible fixed-principal Treasury note, bond or TIPS into separate zero-coupon pieces, each paying once at maturity, and bills and floating rate notes cannot be stripped, under 31 CFR 356.31, so maturities can be lined up with interest payment dates, which is the approach the Treasury portfolio guide takes up.

The MSRB glossary notes that STRIPS have the economic and trading characteristics of a zero coupon bond.

For the shortest windows, Demand Deposit SLGS are one-day certificates that roll over automatically each day until redeemed, at a rate that is an adjustment of the average yield at the most recent 13-week Treasury bill auction under 31 CFR 344.7(a).

How a capitalized interest fund is treated under the arbitrage rules, including when capitalized interest can be treated as part of the capital project, is a conclusion for bond counsel and tax counsel.

The investing questions specific to that fund are taken up in the guide to capitalized interest funds.

What does the arithmetic look like in a worked example?

The two effects run in sequence on an illustrative issue: capitalized interest carries the construction years, and credited earnings enter the numerator only if the documents say so.

For illustration only, say an issuer closes a $50 million revenue bond issue for a treatment plant, allocates $46 million to a construction fund and $4 million to a capitalized interest fund sized to pay two years of interest at $2 million a year, and expects annual debt service of $4 million once the bond amortizes.

In the two construction years, the fund owes $2 million of interest each year, and if the investment on it credits $160,000 over the two years, then $3.84 million of bond principal set aside would have covered the same $4 million of interest.

When the plant operates, say projected net revenues are $4.6 million a year against $4 million of annual debt service, for coverage of 1.15 times on operations alone.

If the indenture counts investment earnings on the issuer's funds and accounts within available revenues, and a debt service fund investment credits $120,000 in the year, the numerator becomes $4.72 million and coverage is 1.18 times.

If the same indenture excluded fund earnings, the same $120,000 would leave coverage at 1.15 times, which is the point: the documents, not the investment, decide whether earnings count.

Earnings that enter the numerator still sit inside the arbitrage rules on a tax-exempt issue, on the terms described above.

mGIC is an independent, SEC-registered municipal advisor that helps issuers structure, competitively bid and close investments of bond proceeds, as reinvestment advisor across fund objectives, permitted investments, draw schedules and credit terms, and as Bidding Agent across bid specifications, provider solicitation and bid comparison.

Whether earnings count in a given issue's coverage, and how a capitalized interest fund is treated for arbitrage, are conclusions for bond counsel and tax counsel.

If you want an independent read on how your fund investments line up with your bond documents, you can talk to mGIC about a no-obligation reinvestment review, and an issuer with an investment already in place can put it to a review against its own terms.

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.