For many years, investment yields were so low that the arbitrage rules applicable to tax-exempt bonds were for the most part more theoretical than practical. But due to rising short-term interest rates, issuers can now often earn an investment yield that exceeds the yield on their bonds.

The two sets of arbitrage rules—yield restriction (which limits the yield on the investment of bond proceeds) and rebate (which requires that earnings above the bond yield be periodically paid to the federal government)—are separate requirements with different rules of application and exceptions that can lead to situations in which issuers may need to pay any earnings above the bond yield (the arbitrage) to the federal government. Below are some of these instances as well as some ways in which issuers may best position themselves to minimize unanticipated out-of-pocket liabilities.

Current refundings: Spend all proceeds within six months or rebate arbitrage to the Federal Government

An exception to yield restriction allows issuers to invest bond proceeds above the bond yield for up to 90 days in a current refunding escrow, effectively allowing them to downsize their bond issues by using the arbitrage earnings for the refunding. Current refundings may also qualify for an exception to rebate, allowing issuers to keep the arbitrage, but only if all proceeds of the refunding issue are spent within six months of the date of issuance (other than a minor portion for certain issues which must be spent within one year) (the 6-Month Spending Exception). The 6-Month Spending Exception requires expenditure not only of amounts in the refunding escrow but also any additional bond proceeds such as amounts set aside for costs of issuance. If there are any unspent proceeds after all costs of issuance have been paid (for example, from a built-in contingency or rounding amount) and such residual amounts are not timely expended, the 6-Month Spending Exception will not be met, and the arbitrage from the escrow generally will give rise to a rebate liability. Since the issuer would have spent the escrow earnings on the refunding, the issuer may then need to come out of pocket to make the rebate payment. To ensure the issue qualifies for the 6-Month Spending Exception and to avoid the rebate liability, issuers generally would be best served by using any unspent proceeds to make eligible expenditures within six months of issuance, for example by paying a portion of an early first interest payment.

Additional rebate exceptions for new money project funds

Tax-exempt bond proceeds for new money projects may generally qualify for a three-year exception to yield restriction, allowing issuers to invest their project funds above the bond yield for the first three years after issuance and to use those excess earnings for additional project costs. However, unless the bonds also qualify for an exception to rebate, the issuer may not fully realize the benefit of those earnings, as the arbitrage must be rebated to the federal government. In addition to the 6-Month Spending Exception, other exceptions to rebate may apply for new money issuances if the relevant proceeds are spent in accordance with one of the following spenddown schedules:

  1. at least 15 percent within six months, 60 percent within one year and 100 percent (other than reasonable retainage) within 18 months (the 18-Month Spending Exception), or
  2. in the case of construction financings, at least 10 percent within six months, 45 percent within one year, 75 percent within 18 months and 100 percent (other than reasonable retainage) within two years (the 24-Month Spending Exception).

Issuers may benefit from taking into consideration these rebate exceptions when sizing their new money bond issuances, i.e., issuing an amount of bonds that they are comfortably able to spend within these time frames. Qualifying for a rebate exception allows issuers to keep the arbitrage earnings in their project funds for additional project costs without incurring a rebate liability. For issuances that will not qualify for a rebate exception, issuers may wish to consider setting aside a portion of the earnings on the project fund to pay rebate, rather than using such amounts for additional project costs and then later needing to come out of pocket to satisfy the rebate liability.

Project fund earnings after three years

As noted above, new money project funds generally qualify for a three-year exception to yield restriction. Following the end of the three years, amounts remaining in the project fund become subject to yield restriction but qualify for “yield reduction payments”; meaning that rather than actually restrict investment yields, issuers may instead make periodic payments to the federal government to reduce the yield on their investments. While this concept is similar to rebate, differences in the application of the yield restriction and rebate rules may result in situations in which issuers do not have a rebate liability but nevertheless need to make yield reduction payments. For project funds established prior to the rise in interest rates, there may have been a period of time when the project fund was earning substantial negative arbitrage (i.e., the fund may have been invested well below the bond yield). For purposes of rebate, these early years of negative arbitrage are taken into account, such that later years of higher earnings are blended with the earlier lower earnings, decreasing any rebate liability potentially down to zero. For purposes of yield restriction, however, the negative arbitrage from the first three years is not taken into account because yield-restricted investments cannot be blended with non-yield-restricted investments. Thus, issuers may need to make yield reduction payments to reduce the yield on the investment of the project fund after the first three years, even though they do not owe any rebate. Issuers with project funds spanning the lower and higher interest rate environments should closely monitor their investment yields and consider whether to expend their excess earnings on additional projects (and later have to come out of pocket for yield reduction payments) or retain the excess earnings to make yield reduction payments.


The above are just some of the instances in which the interplay of the yield restriction and rebate rules may yield (no pun intended) unexpected results. In the current interest rate environment, issuers are advised to closely track their investment earnings and coordinate with their advisors, including bond counsel, financial advisors and rebate analysts, to ensure continued compliance with the arbitrage rules and to put themselves in the best position with respect to their investment earnings.


Senior Counsel

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