bond-basics

Yield

As computed under the Code provisions applicable to Bonds, the internal rate of return that causes the present value of the payments of Principal and Interest (and, in certain cases, certain other payments) on an Issue of Bonds to equal the Issue Price of the Bonds. In most cases, the calculation is made assuming that the Bonds are all outstanding to their respective Maturity or Mandatory Sinking Fund Redemption date.  For a Fixed Rate Bond Issue, the Yield is determined once as of the date of the Closing. For a Variable Rate Bond Issue, the Yield must be determined periodically during the term of the Bonds.

Yield is calculated as set forth in Section 148(b) of the Code and Treasury Regulations Sections 1.148-4 and 1.148-5. Different rules apply to fixed Yield Bond Issues as opposed to variable Yield Bond Issues. For fixed Yield Bond Issues, Yield on the Bonds generally means that discount rate which, when used in computing the present value of all unconditionally payable payments representing Principal, Interest and payments with respect to qualified guarantees or qualified hedges, produces an amount equal to the adjusted aggregate Issue Price of the Bonds. This calculation is done as of the issue date of the Bond Issue, and, except in certain rare circumstances, the Yield does not change after the Bonds are issued. For variable Yield Bond Issues, the Yield on the Bonds is computed separately for each computation period, as defined in Treasury Regulations Section 1.148-1(b). The Yield for each computation period is the discount rate which, when used in computing the present value as of the first day of the computation period of all payments of Principal, Interest, and payments with respect to qualified guarantees and qualified hedges that are attributable to the computation period, produces an amount equal to the present value of the aggregate Issue Price (or the deemed Issue Price for any computation period other than the computation period beginning on the issuance date) of the Bonds as of the first day of the computation period. This calculation cannot be done on the issue date of the variable Yield Bond Issue because, by definition, the Issuer does not know how much Interest will be paid (nor when it will be paid) over the life of the Bonds.  As you can see from the definition above, computation of Yield for both fixed and variable Yield Bond Issues depends on the Issue Price of the Bonds.


Yield Restrictions

The basic Yield restriction rule provides that Gross Proceeds of a Bond Issue may not be invested at a Yield “materially higher” than the Yield on the Bonds except for a “Temporary Period” or pursuant to another exception. Once the Bond proceeds can be treated as spent (or, to use the tax lawyer’s jargon, “allocated to expenditures”), then they are no longer subject to the Arbitrage and Rebate rules.  Simply paying the proceeds to someone else is not enough to treat the proceeds as no longer subject to the Arbitrage rules.  For example, if an Issuer pays Bond proceeds to an unrelated construction contractor to build a building, that payment is treated as a valid expenditure under the Arbitrage rules, and the Issuer does not have to continue to monitor what is done with those amounts in the hands of the contractor.  In contrast, if the Issuer pays the Bond proceeds to an employee for their regular work (which is a “working capital” expenditure for tax purposes), those proceeds might not be treated as spent, even though the Issuer has paid them to someone else.

Materially Higher

The Yield on investments is materially higher than the Yield on the Bond Issue if the Yield on the investments over the term of the investments exceeds the Yield on the Bond Issue by an amount in excess of the applicable definition of materially higher set forth in the Treasury Regulations.  The permitted spread between the Bond Yield and investment Yield depends on the class of investment (as described in the Treasury Regulations) and the purpose for which the invested proceeds are held.  No Yield limitation applies to investments that are themselves Tax-Exempt Bonds that are not subject to Alternative Minimum Tax.  In other words, an Issuer can use Tax-Exempt Bond proceeds to buy other Tax-Exempt Bonds that are not subject to Alternative Minimum Tax and earn a return on those invested proceeds that exceeds the Yield the Issuer pays to the holders of the Tax-Exempt Bonds.

Temporary Period

The period of time (often set forth in the tax certificate), during which a particular category of proceeds may be invested in higher yielding investments without the issue being treated as arbitrage bonds under Section 148 of the Code.

Yield Restriction Exceptions

In addition to the Temporary Periods, which, as their name suggests, are temporary, there are certain exceptions to the prohibition on investing proceeds above the Bond Yield that apply for the life of the Bond Issue. A Minor Portion may be invested at an unrestricted Yield.  In addition, a Reasonably Required Reserve or Replacement Fund may be invested at an unrestricted Yield.

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See Also

Arbitrage

Profit from differences in markets. All tax-advantaged bonds are subject in one way or another to the arbitrage requirements, which are contained in Section 148 of the Code and the Treasury Regulations that go along with it.

Rebate

A requirement imposed under the Code to pay to the Internal Revenue Service an amount equal to the arbitrage earned on tax-exempt bonds.

Principal

The face amount or par amount of a bond, not including interest, payable on its maturity date.

Interest

The amount of compensation for the use of borrowed money paid to the bondholders by the issuer or the borrower.

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Inducement Resolution

A resolution adopted by the issuer or the borrower to indicate the preliminary intention to issue the tax-exempt bonds, subject to satisfaction of certain conditions precedent which may be satisfied on or after the adoption of a bond resolution.