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Definition: Refunding Escrow Deposits – REDs
Refunding Escrow Deposits or REDs are forward contracts that make it obligatory for an investor entering into the contract to purchase bonds at a future date at a specified rate. Prior to the date of bond issue, the money from investors is invested in Treasury securities. This investment is said to be held in escrow via investment in Treasury bonds until the Treasury bonds are mature or are sold. The proceeds from the Treasury securities around the call date of the existing bond issue are then used to invest in the new bond issued. The yield rate for this new issue is predetermined by the forward contract.
The advantage of REDs is that investors can benefit from the interest payments from Treasury bonds invested in the escrow account during the interim period until the new bonds are issued. REDs enable investors to circumvent tax restrictions that prevented prerefundings of projects. Prerefunding allows investors to get into a forward contract to lock in a lower rate when the market rates are expected to increase. REDs are financial instruments that provide the benefit of prerefunding by making it obligatory for investors entering the contract to purchase bonds at the predetermined lower rate.
The future date at which the investor is obligated to purchase the new issues is usually the first call date for an existing high-rate bond. The investment into Treasury bonds provides investors with security of their investment and a continuous taxable income. When the Treasury bonds are sold or redeemed around the call date of the new bond issues, the investor can use the proceeds to purchase the new issues or redeem old bonds.
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