CDFA Spotlight: Yield Burning By Stan Provus

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This article demonstrates the concept of “yield burning”.
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“Yield burning” refers simply to the artificial lowering of a security’s yield by pricing it in excess of its fair market value. Yield and price have an inverse relationship: as the price of a security goes up, its yield goes down. Securities purchased with the proceeds of tax-exempt municipal bonds must (1) be priced no higher than “fair market value,” and (2) earn an aggregate yield that does not exceed that earned on the tax-exempt municipal bond.

For example, an issuer may purchase securities with bond proceeds. These securities include Guaranteed Investment Contracts (GICs), and Open Market Treasury Securities (OMTS), among other investments. These securities may be purchased to invest construction funds or debt service reserve funds. Other securities may be purchased for refunding escrows. Overstating the fair market value of GIC, OMTS, or other investments, using unreasonable collateralization requirements and/or charging excessive administrative costs (i.e. broker’s commissions) to artificially reduce the yield and, in effect, divert otherwise rebateable arbitrage from these investments to investment professionals/providers constitutes “yield burning” which is an abuse of IRS arbitrage rules and subject to penalties.

The “arbitrage” of public, tax-exempt bond proceeds is at the heart of the yield-burning. Bond arbitrage occurs when any portion of the proceeds from a tax-exempt bond is used — either directly or indirectly — to acquire higher-yielding investments. State and municipal bonds receive the benefit of federal tax exemption (which effectively lowers the interest rates paid to bondholders and thereby lowers the municipalities' costs), and for that reason their bond proceeds may only be used in a manner that furthers the intended public purpose of the bond.

The investment of tax-exempt bond proceeds for profit is not regarded as a valid public purpose and is strictly prohibited as a result. Issuers of tax-exempt bonds are barred from earning a higher yield on their investment of the bond proceeds than they pay in interest to bondholders. This prohibition is termed “yield restriction.” Federal law requires that the Treasury be reimbursed for any “positive arbitrage” — or profit — that is obtained from the investment of bond proceeds at yields above the yield-restricted rate.

To avoid yield burning, issuers should observe sound practices in securing investment contracts such as GICs from providers. Securities purchased with bond proceeds must be purchased at “fair market value.” Treasury regulations proscribe certain procedures that must be followed to establish fair market value. For example, at least three reasonably competitive providers must be solicited for GIC bids and these providers should not have a material financial interest in the issue. Issuers should work with their bond counsels to assure that all regulations are observed to prevent “yield burning.”

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.