Escrowed To Maturity

Escrowed to maturity securities refer to a form of pre-funded municipal bonds. In this case, the issuer holds proceeds from a new bond issue in an escrow account, and invests them in high credit securities, to fund interest and the principal payments to the original bondholder. 

Escrowed to maturity describes issuers' investing and holding new bond sales in an escrow account, then using the sales to cover obligations to the owners of a previously issued bond. 

Pre-funded municipal bonds, which include escrowed to maturity bonds, are securities that a bond issuer has called, or bought back, from the bondholder before it has matured. Issuers often make calls during periods of declining interest rates; by paying off their high-interest debt, the issuer can sell new bonds at lower rates. However, most bonds contain provisions that prevent the issuer from making that call before a specific date, typically some years after they’ve been issued. So if the issuer wants to take advantage of lower rates before that call date arrives, they might use pre-funded bonds.

Here, the issuer sells new bonds to cover the cost of calling those bonds that they’ve already issued. On reaching the call date of the original bonds, the issuer uses proceeds from the new bond sales to pay their owners. In this particular case, the issuer invests proceeds from its distribution of the new bonds in U.S.Treasuries and holds them in an escrow account. By selecting Treasuries that mature at the same time they call the original bonds, the issuer can repay the principal and full interest owed at maturity of the outstanding bond to the original bondholders.

Escrowed to maturity bonds are unique in that they possess the tax-advantaged treatment of a municipal bond with the relative safety of government-issued security. The result: A potentially better after-tax yield than an investor would receive on a bond of similar duration and risk.

For example, you’re choosing between a two-year Treasury and a municipal bond with an original maturity of 10 years escrowed to maturity in two. It is likely that called municipal bonds will offer a superior yield to the Treasury, but the also, the interest it produces will be free of both State and Federal taxes.