A defeased bond is a bond whose remaining interest and principal payments are covered by a dedicated portfolio of risk-free securities held in an irrevocable trust, rather than by the original issuer’s ongoing cash flow. The bond stays legally outstanding, but the credit risk shifts from the issuer to the trust assets. Corporations, state and local governments, and commercial real estate borrowers all use defeasance, usually to escape restrictive covenants, refinance high-cost debt before it can be called, or clear a loan off a property they want to sell.
How Defeasance Works
The mechanics are straightforward once you see the pieces. The issuer starts by calculating the present value of every remaining payment on the bond. That figure sets the budget for substitute collateral.
The issuer then buys a portfolio of securities whose 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 generate exactly those amounts on exactly those dates. An independent verification agent, typically a CPA firm, certifies that the escrow cash flows will cover every remaining payment.
Those securities go into an irrevocable trust run by an escrow agent. The issuer cannot reclaim the assets under any circumstance. From that point on, the escrow agent pays the bondholders directly out of the trust. The bond still exists on paper, but the issuer’s economic obligation has been fully collateralized.
What Sits in the Trust
Bond indentures spell out which securities qualify as escrow collateral, and the list is short by design. In nearly every case, the trust holds direct obligations of the U.S. government: Treasury notes, Treasury bonds, and zero-coupon Treasury strips. A few indentures also allow federal agency debt.
Municipal issuers frequently use State and Local Government Series (SLGS) securities, which the U.S. Treasury sells directly for this purpose. SLGS are non-marketable and can be tailored to match the defeased bond’s payment schedule precisely. Their interest rates are also yield-restricted to help tax-exempt issuers stay compliant with federal arbitrage rules.1eCFR. Part 344 U.S. Treasury Securities – State and Local Government Series
One structural rule matters: the escrow securities must be essentially risk-free as to both timing and amount. Callable securities do not qualify, because the government could redeem them early and disrupt the cash flow match.2Governmental Accounting Standards Board (GASB). Statement No. 86, Certain Debt Extinguishment Issues
Legal Defeasance and In-Substance Defeasance
Two versions of defeasance exist, and the difference between them drives everything else — accounting, tax treatment, and credit ratings.
Legal Defeasance
A legal defeasance fully releases the issuer from any further obligation under the bond. Bondholders accept the trust as their sole source of repayment, and the issuer walks away with no residual liability. This works only when the original indenture contains an explicit defeasance clause permitting the substitution, and a legal opinion confirming the release is required. Once complete, the debt is extinguished for both legal and accounting purposes.
It is the less common form because many older indentures never included the necessary language. When available, though, it is the cleanest outcome: the obligation disappears entirely from the issuer’s books.
In-Substance Defeasance
In-substance defeasance is far more common. The issuer funds the same kind of irrevocable trust, but is not legally released from the debt. If something were to go wrong with the escrow, which is a remote scenario when the trust holds only Treasuries, the issuer would still be liable.
Economically, the risk of nonpayment is eliminated. Government issuers can remove the debt from their balance sheets under GASB rules, so long as the trust is properly structured and the chance of the government ever making a payment on that debt is remote.3Governmental Accounting Standards Board. Summary of Statement No. 86 Corporate issuers face a tougher standard: current GAAP generally requires legal release before the debt can come off the balance sheet.
Why Issuers Defease Bonds
Calling a bond early or buying it back on the open market might look simpler, but those options are often unavailable or uneconomic. Defeasance fills the gap.
The most common trigger is a bond that cannot yet be called. Many bonds carry call protection lasting five or ten years. During that window, the issuer cannot repay early. Defeasance sidesteps the restriction by leaving the bond outstanding while removing its economic burden.
Shedding restrictive covenants is another major reason. Bond indentures often cap future borrowing, require the issuer to maintain specific financial ratios, or restrict asset sales. Once the debt is defeased and functionally removed from the balance sheet, those covenants lose their grip. For an issuer eyeing an acquisition or a major capital project, that operating freedom can outweigh the cost of the defeasance itself.
Interest rate arbitrage plays a role too. When prevailing rates are lower than the bond’s coupon, the issuer may be able to fund the escrow for less than the bond’s carrying value, producing a gain on extinguishment. Even without an outright gain, the issuer can issue new lower-rate debt to fund the escrow and effectively refinance without waiting for the call date.
The cleanup effect on the balance sheet also matters. Removing a large liability immediately improves leverage ratios, which can help satisfy lender covenants, support credit ratings, or make the issuer more attractive in a sale.
What It Means for Bondholders
For a bondholder, defeasance is almost always good news. Your payments are now backed by U.S. Treasuries rather than the credit of a corporation or a municipality. The credit risk drops to essentially zero, which is why legally defeased bonds can carry AAA ratings.
S&P Global Ratings has said that a properly consummated legal defeasance backed by Treasuries should warrant a AAA rating, provided S&P can verify the transaction through legal opinions. Where those opinions are unavailable, S&P discontinues the rating and marks the bond Not Rated. In-substance defeasance produces a smaller upgrade because the issuer remains legally on the hook; S&P has historically rated those bonds up to three notches above the issuer’s corporate credit rating.4S&P Global Ratings. Defeasance Of Corporate Bonds May Be Gaining Popularity
There is a trade-off. Once a bond is defeased, it often stops trading actively because the credit story is over. If the bond had been yielding a premium over Treasuries to compensate for issuer risk, that spread compresses or disappears. You still receive every scheduled payment, but if the bond is called at the earliest available date, you will need to reinvest that capital in whatever the market offers then.
Bondholders do not vote on defeasance. If the indenture permits it, the issuer proceeds without needing consent. The protection lies in the structure itself: an irrevocable trust, risk-free assets, independent verification, and no path back to the issuer’s balance sheet. The residual risk to watch for is a loosely drafted trust agreement that would allow risk-free securities to be swapped for something riskier after closing. GASB 86 requires government issuers to disclose whether that substitution risk exists, and corporate bond investors have to read the trust agreement itself to check.3Governmental Accounting Standards Board. Summary of Statement No. 86
Tax Treatment for the Issuer
The IRS does not always follow the accounting rules. Whether a defeasance triggers a taxable event depends on the type of defeasance and the terms of the original debt.
Under 26 CFR § 1.1001-3, a legal defeasance that releases the issuer from all liability is a significant modification of the debt instrument. That is a deemed exchange for tax purposes, so the issuer recognizes gain or loss as if it had retired the old bond and issued a new one.5eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
An in-substance defeasance where the issuer stays obligated is treated differently. If the option to defease was built into the original bond terms and the issuer exercises it unilaterally, the release of covenants is not a modification at all under the regulations, and no taxable exchange occurs.5eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
Tax-exempt bonds get a carve-out. Even a legal defeasance of a tax-exempt bond is not a significant modification, so long as the defeasance occurs under the original bond terms and the trust holds qualifying government securities.5eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
Municipal issuers face an added constraint from the 2017 tax law. Under 26 U.S.C. § 149(d), interest on any bond issued to advance refund another bond no longer qualifies for the federal tax exemption.6Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered to Be Tax Exempt A municipality can still defease outstanding debt using cash reserves already on hand, but it cannot issue new tax-exempt bonds to fund the escrow when the call date is more than 90 days away.
Defeasance Outside the Bond Market
The term shows up beyond public debt, most often in commercial real estate. Loans that have been securitized into commercial mortgage-backed securities (CMBS) usually prohibit outright prepayment, because investors in the pool are relying on the scheduled cash flows. The loan agreement typically requires defeasance instead.
The mechanics mirror bond defeasance. The borrower buys a Treasury portfolio whose cash flows replicate every remaining loan payment, and those securities take the place of the real property as collateral. The borrower can then sell or refinance the property free and clear, and the loan servicer keeps receiving the same payments from the escrow.
The cost can be significant. The Treasury portfolio almost always costs more than the remaining loan balance, because Treasury yields are lower than the loan’s interest rate, and transaction costs typically run $50,000 to $100,000 for attorneys, accountants, a defeasance consultant, and the verification agent. From start to close, the process usually takes 30 to 45 days, though each loan sets its own requirements.