What is a defeased bond?

What is a Defeased Bond?

A defeased bond is a bond that has been rendered essentially risk-free by setting aside sufficient assets in a trust to cover all future payments of principal and interest. This process, known as defeasance, ensures that the bondholders will receive their promised payments, even if the issuer encounters financial difficulties. Defeasance is commonly used in the context of municipal and corporate bonds to remove the bonds from the issuer's balance sheet, allowing for more financial flexibility or to meet certain legal requirements.

How is Defeasance used in Real Estate?

In real estate, defeasance is often used in the context of commercial mortgage-backed securities (CMBS) loans. Property owners use defeasance to essentially "prepay" their loan without actually paying it off early, which might be prohibited under the loan terms. Instead, they replace the original collateral (the property) with a portfolio of government securities (like Treasury bonds) that generates enough income to cover the remaining scheduled loan payments.

This process allows the property owner to be released from the lien on the property, enabling them to sell or refinance the property before the loan matures while ensuring the CMBS investors continue receiving their expected cash flows. Defeasance is a strategic tool for property owners seeking flexibility in managing their real estate assets and liabilities.