9.5.1 Arbitrage Rebate and Yield Restriction

Proceeds of tax exempt bonds, unlike other governmental funds, are subject to federal tax laws respecting arbitrage, including provisions restricting the yield on the investment of certain bond funds and arbitrage rebate, requiring earnings in excess of the yield on the bonds to be paid to the U.S. Treasury. The yield restriction requirements of the arbitrage rules are discussed in Section 4.8, Arbitrage Yield Restriction. Arbitrage rebate requirements are discussed in Section 4.9, Arbitrage Rebate and Section 8.3, Post-Issuance Federal Tax Law Requirements.

For investment of bond funds, these federal tax law provisions have three important implications:

Bond fund investments must be separable (directly or by allocation) from other funds. Bond funds and investment proceeds of bond funds should be monitored and tracked as part of a public agency’s processes for monitoring all of its funds. For tax exempt debt, bond funds should not be commingled with general funds of the public agency.
It is often essential to know the exact yield on bond fund investments, which may be greater than the yield actually realized on the investments. Following the requirements of the federal tax law “safe harbors” and other rules for determining the prices at which investment securities are acquired or disposed of is important, especially with respect to securities such as investment agreements or defeasance escrow portfolios, for which there is no established market.
Because investment returns in excess of the yield on the bonds accrue to the benefit of the U.S. Treasury under arbitrage rebate rules, while investment losses are borne by the agency, public agencies should be encouraged to take a more conservative approach when investing bond funds.