What Does It Mean to Defease Municipal Bonds?

To defease municipal bonds is to set aside a dedicated escrow of cash and investments whose principal and interest are scheduled to pay an outstanding bond issue.

The MSRB glossary splits the idea in two: a legal defeasance ends bondholders' rights and lien under the bond contract, while an economic or financial defeasance leaves the issuer liable if the deposited funds prove insufficient.

When a refunding funds the defeasance, the escrow is the refunding escrow covered in how a refunding escrow is structured and funded, and the refunding structures that produce one are covered in the types of bond refundings.

This page covers what the two kinds of defeasance do to the issuer's obligations, how the escrow behind them is funded, and what happens to proceeds the escrow does not absorb.

What is the difference between legal and economic defeasance?

In a legal defeasance the bond contract ends bondholders' rights and lien, while in an economic or financial defeasance the funds are set aside but the MSRB glossary notes the issuer would continue to be legally obligated to make payment if the deposited funds prove insufficient.

The glossary's distinction runs as follows.

That contrast is why the labels matter beyond terminology: one ends bondholders' rights and lien under the bond contract, and the other leaves the issuer's obligation in place behind the escrow.

The MSRB glossary also labels the bonds themselves: bonds are escrowed to maturity when the escrow pays them on their original schedule, and prerefunded when the escrow runs only to a call date or dates, with the refunded issue redeemed at that time.

Which refunding produced the escrow carries a tax line: under Internal Revenue Code §149(d)(2) a bond is an advance refunding bond if it is issued more than 90 days before the refunded bond is redeemed, and §149(d)(1) provides that interest on any bond issued to advance refund another bond is not exempt from federal income tax.

That provision was added by Pub. L. 115-97 §13532 for advance refunding bonds issued after December 31, 2017, and it left current refundings and taxable advance refundings available, with the fit for a given issue a question for bond counsel and tax counsel.

The 90-day line is the federal tax definition only: the MSRB notes that refundings of less than 90 days may still count as advance refundings under state law or bond contracts.

How is a defeasance escrow funded?

Funding a defeasance escrow means building a portfolio whose payments land on the defeased bonds' dates, and the escrow deposit agreement is the document that sets out the manner in which funds are to be invested and the schedule on which ongoing debt service payments are made, in the MSRB glossary's description.

When the escrow is funded by a refunding, Treasury Regulation §1.148-1(b) defines a refunding escrow, for arbitrage purposes, as one or more funds established as part of a single transaction or a series of related transactions, containing proceeds of a refunding issue and any other amounts to provide for payment of principal or interest on one or more prior issues.

The MSRB glossary says the proceeds of an advance refunding are generally invested in Treasury securities or federal agency securities, although other instruments are sometimes used.

The Treasury program built for this is the State and Local Government Series (SLGS), which the MSRB describes as most commonly used for deposit in an escrow account in connection with the issuance of refunding bonds.

The escrow's investment horizon follows the redemption plan, since GFOA notes that for an escrow the horizon depends on the redemption date, which is what separates an escrow running to maturity from one that stops at a call.

GFOA's refunding guidance divides the work around the escrow among three roles.

The MSRB describes a verification report as one prepared by a certified public accountant or other independent third party that verifies the yield of the investments held in escrow in connection with an advance refunding bond issue, and it shows their cash flow is enough to pay principal and interest on the refunded bonds.

The line-by-line checklist behind that report is covered in what an escrow verification agent checks.

Buying SLGS for the escrow takes an eligible source of funds, and 31 CFR 344.1 defines those categories to include amounts held with gross proceeds in a refunding escrow, defeasance escrow, parity reserve fund or commingled fund.

Whether a particular fund qualifies is a question for bond counsel, and the instrument choice for a given escrow is compared in SLGS vs open-market escrow funding.

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, and it notes the SEC and IRS view the practice as illegal.

The SEC's municipal advisor release made the same point from the enforcement side, describing escrow investments as particularly vulnerable to abuse and citing historic yield-burning enforcement (SEC Release No. 34-70462).

That practice is covered in what yield burning is.

Whether escrow work is municipal advisory activity turns on the advice: Section 15B(e)(3) of the Exchange Act defines investment strategies to include plans or programs for investing municipal securities proceeds and the recommendation and brokerage of municipal escrow investments, a definition SEC Rule 15Ba1-1(b) adopts.

The same release drew the line at the other end: the purchase and sale of escrow investments on the direction of an obligated person or its financial advisor without rendering advice is merely a provision of brokerage services and does not render such person a municipal advisor, while giving advice on those investments does (SEC Release No. 34-70462).

GFOA adds that a municipal advisor, if the issuer has engaged one, may be able to act as the escrow bidding agent, and if you are planning an open-market funding, mGIC can bid your escrow as part of a free, no-obligation conversation.

What happens to unspent proceeds in a defeasance?

When a refunding funds the defeasance, proceeds of the refunding issue, including any the escrow does not absorb, fall under the refunding temporary periods in Treasury Regulation §1.148-9(d)(2).

Under that section, proceeds of a refunding issue other than transferred proceeds generally get a 30-day temporary period, and proceeds of a current refunding issue get 90 days, or at most 30 days if the refunding issue's original term is 270 days or less.

Transferred proceeds, which Treasury Regulation §1.148-9 defines as proceeds of a refunded issue that become proceeds of the refunding issue, follow their own separate temporary period rules under §1.148-9(d)(2)(iii).

How those windows interact with the yield limits is covered in what yield restriction is and in how long proceeds can be invested without yield restriction.

31 CFR 344.1 lists, among the eligible sources of funds for SLGS, amounts held with gross proceeds in a refunding escrow, defeasance escrow, parity reserve fund or commingled fund, and amounts released from gross-proceeds status by the universal cap in Treasury Regulation §1.148-6(b)(2).

The eligibility call for any particular fund belongs to bond counsel, and the wider question of redirecting leftover money is covered in what an issuer can do with unspent bond proceeds.

Who makes the final calls on a defeasance?

The financing team splits the work: whether the bond contract releases the issuer and ends bondholders' rights is a legal conclusion for bond counsel, the arbitrage and tax consequences are conclusions for tax counsel, and the sufficiency of the escrow is what the verification agent confirms.

mGIC's own lane is narrow: it is an independent, SEC-registered municipal advisor that owes its municipal clients a fiduciary duty, it sells no proprietary investment product, and it does not act as principal in the investments it evaluates.

As Bidding Agent it prepares bid specifications, solicits qualified providers, manages questions during the solicitation, and receives and compares bids on rate and non-rate terms, before coordinating documentation and delivering Bidding Agent and provider certifications to bond counsel.

Its fee is paid by the winning provider rather than the issuer, at or below the safe-harbor maximum in the Treasury arbitrage regulations, and it is disclosed under those regulations.

Founded in 2002, the firm has more than $60 billion in bond proceeds invested and swap notional executed across more than 1,000 transactions for issuers in more than 40 states.

For a review of an escrow or a defeasance plan, contact mGIC for a free, no-obligation conversation.

Final determinations about a particular issue, from the release of bondholders' rights to the arbitrage conclusions, belong to 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.