A defeased bond is a bond whose remaining interest and principal payments are guaranteed not by the original issuer but by a portfolio of risk-free securities the issuer has placed in an irrevocable trust. The trust holds enough U.S. Treasuries (or similar government obligations) that their cash flows match every payment still owed on the bond, dollar for dollar and date for date. The bond itself remains legally outstanding, but the credit risk has effectively moved off the issuer and onto the collateral in the trust.
Corporations, state and local governments, and commercial real estate borrowers all use defeasance. The reasons vary, but the structure is the same: substitute rock-solid collateral for the issuer’s promise to pay, and the bond behaves, from that point on, more like a Treasury than like the debt of whoever originally borrowed the money.
How the Substitution Works
The issuer starts by calculating the present value of every remaining principal and interest payment on the bond. That number sets the funding target. The issuer then buys a portfolio of securities whose scheduled cash flows line up with the bond’s payment schedule in both timing and amount. If the bond pays $2 million in interest every June 15 and December 15 for the next eight years, the trust portfolio must throw off exactly those amounts on exactly those dates.
An independent verification agent, usually a CPA firm, certifies that the escrow’s cash flows are mathematically sufficient to cover the remaining payments. The securities are then transferred into an irrevocable trust managed by an escrow agent. The issuer cannot reclaim the assets under any circumstances. From that point on, the escrow agent, not the issuer, makes the bond payments.
What Sits in the Trust
Indentures and loan agreements are strict about what qualifies as escrow collateral. In almost every case, the permitted investments are limited to direct obligations of the U.S. government: Treasury notes, Treasury bonds, and zero-coupon Treasury strips. Some indentures also allow federal agency securities, but that is less common.
For municipal defeasances, issuers often buy State and Local Government Series (SLGS) securities directly from the U.S. Treasury. SLGS are non-marketable securities designed for this purpose, with interest rates and maturity dates tailored so they can match a defeased bond’s payment schedule precisely.1eCFR. Part 344 U.S. Treasury Securities – State and Local Government Series They also help municipal issuers stay within the federal arbitrage rules, because SLGS can be yield-restricted to the arbitrage yield on the tax-exempt debt being defeased.
One restriction runs through all of this: the securities in the trust must be essentially risk-free as to both timing and amount. Callable securities do not qualify, because the government could redeem them before their scheduled maturity and disrupt the cash flow match.2Governmental Accounting Standards Board (GASB). Statement No. 86, Certain Debt Extinguishment Issues
The Two Kinds of Defeasance
Not every defeasance releases the issuer to the same degree, and the distinction matters for accounting, taxes, and credit ratings.
Legal Defeasance
Legal defeasance fully releases the issuer from any obligation under the bond. Bondholders accept the trust as their sole source of repayment, and the issuer walks away with no residual liability. This is only possible when the original indenture contains an explicit defeasance clause, and a legal opinion confirming the release is required. The debt is extinguished for both legal and accounting purposes.
Legal defeasance is the less common form because many older indentures lack the necessary language. When it is available, it offers the cleanest outcome: the debt disappears from the issuer’s books and obligations entirely.
In-Substance Defeasance
In-substance defeasance is far more common. The issuer funds an irrevocable trust that will cover every remaining payment, but the issuer is not legally released. If something went wrong with the escrow, a remote scenario when the trust holds only Treasuries, the issuer would still be on the hook.
Despite that lingering legal obligation, the risk of non-payment is economically eliminated. Government issuers can remove this debt from their balance sheets under GASB rules, provided the trust is properly structured and the possibility of future payments by the government is remote.3Governmental Accounting Standards Board. Summary of Statement No. 86 Corporate issuers face stricter standards under current GAAP, which generally require legal release before the debt can come off the balance sheet.
Why an Issuer Would Do This
Calling a bond early or buying it back on the open market can look simpler, but defeasance often makes more sense. The most common driver is call protection. Many bonds have five- or ten-year windows during which the issuer cannot repay the debt early. Defeasance sidesteps the restriction by leaving the bond outstanding while eliminating its economic burden.
Shedding restrictive covenants is another major reason. Bond indentures often cap future borrowing, require specific financial ratios, or restrict asset sales. Once the debt is defeased and functionally removed from the balance sheet, those covenants lose their bite. For an issuer planning an acquisition or a large capital project, that operational freedom can be worth more than the defeasance costs.
Interest rate arbitrage plays a role too. If prevailing rates are lower than the coupon on the outstanding bond, the issuer may be able to fund the escrow trust for less than the bond’s carrying value, producing a gain on extinguishment. Even without an outright gain, an issuer can float new lower-rate debt to fund the escrow, effectively refinancing without waiting for the call date.
Finally, defeasance cleans up the balance sheet. Removing a large debt liability improves leverage ratios, which can help meet lending covenants, support credit ratings, or make the issuer more attractive in a sale or merger.
What It Means for Bondholders
From a bondholder’s perspective, defeasance is almost always good news. Your payments are now backed by U.S. Treasuries rather than by a corporate or municipal issuer’s cash flows. The credit risk drops close to zero, which is why legally defeased bonds can carry AAA ratings.
The trade-off is subtle but real. Once a bond is defeased, it often stops trading actively because the credit story is over. If the bond was yielding a premium over Treasuries because of the issuer’s credit risk, that spread compresses or disappears. You still receive every scheduled payment. But if the bond is called at the earliest opportunity, you face reinvestment risk: redeploying that capital into a market that may offer lower yields than the coupon you were earning.
Bondholders do not get a vote on whether defeasance happens. If the indenture permits it, the issuer can proceed without bondholder consent. The protection lies in the structure of the trust itself: irrevocable, funded with risk-free assets, independently verified, and beyond the issuer’s reach regardless of what happens to the issuer’s finances afterward.
The one wrinkle to watch is escrow structure. If the trust agreement does not prohibit substituting the risk-free assets with riskier investments after closing, the credit quality of the escrow could theoretically deteriorate. GASB 86 requires issuers to disclose whether that substitution risk exists, but corporate bond investors should review the trust agreement directly.3Governmental Accounting Standards Board. Summary of Statement No. 86
How Ratings Agencies Treat a Defeased Bond
The ratings impact depends on which form of defeasance was used. S&P Global Ratings has indicated that a properly consummated legal defeasance backed by Treasuries should carry a AAA rating, assuming S&P can verify the defeasance through legal opinions. If those opinions are unavailable, S&P discontinues the rating and marks the bond as Not Rated.4S&P Global Ratings. Defeasance Of Corporate Bonds May Be Gaining Popularity Either way, the defeased bond drops out of the issuer’s ongoing credit analysis.
In-substance (or “economic”) defeasance produces a more moderate upgrade. Because the issuer remains legally liable, the bond is treated as secured debt with enhanced recovery prospects. S&P has historically rated these bonds up to three notches above the corporate credit rating.4S&P Global Ratings. Defeasance Of Corporate Bonds May Be Gaining Popularity The issuer’s own rating also benefits, since analysts typically net the trust assets against the defeased debt when calculating financial ratios.
Municipal Defeasance After the 2017 Tax Law
Defeasance has become more important for municipal issuers since the Tax Cuts and Jobs Act of 2017 ended tax-exempt advance refunding. Before the change, a municipality could issue new tax-exempt bonds more than 90 days ahead of a call date, park the proceeds in escrow, and use them to pay off the old bonds at the call. That route is closed. Under 26 U.S.C. ยง 149(d), interest on any bond issued to advance refund another bond no longer qualifies for the federal income tax exemption.5Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered to Be Tax Exempt
Municipal issuers can still defease outstanding debt with cash reserves already on hand. That path is governed by GASB 86 and remains a legitimate strategy for managing debt. What they cannot do is issue new tax-exempt bonds to fund the escrow when the call date is more than 90 days away.
Defeasance Beyond the Bond Market
The term shows up outside bonds too, and the mechanics look familiar. Commercial real estate borrowers with loans that have been securitized into commercial mortgage-backed securities (CMBS) often cannot prepay, because investors in the securitized pool are counting on scheduled cash flows. Instead, the loan agreement typically requires the borrower to defease: buy a portfolio of Treasuries whose cash flows replicate every remaining loan payment, and let those securities replace the real property as collateral. The borrower can then sell or refinance the property free and clear, while the servicer and the CMBS trust keep receiving the same payments.
The cost can be substantial. The Treasury portfolio almost always costs more than the remaining loan balance, since Treasury yields are lower than the loan’s interest rate. Transaction costs (attorneys, accountants, a defeasance consultant, and the verification agent) typically run $50,000 to $100,000 on top of that. The whole process from start to close usually takes 30 to 45 days, though each loan agreement sets its own requirements.
Different instrument, same idea: substitute risk-free collateral for the borrower’s promise, and the payments keep flowing without the original obligor in the picture.