Yield burning, a practice of reducing yield by inflating margins on municipal bonds, was outlawed due to its unethical nature. It was used to circumvent US federal law on interest income, and insurers would help find a haven for the extra profit generated. Today, severe penalties apply if discovered.
Yield burning is a practice long considered unethical and eventually outlawed. The procedure to reduce the yield was to place inflated margins on the bonds that were used to complete some forms of municipal bond offerings. This action of increasing the price of the bonds would cause the yield to fall, creating a situation called a burn.
The idea behind the practice was to get around certain aspects of US federal law that have to do with the amount of interest income a municipality could earn on Treasury securities. Under the terms and conditions of the issuance of the securities, the municipality is prohibited from earning more money in interest than what is paid on the debt. By participating in the margins of the bonds, the underwriter of the bond may still earn additional income from the project without affecting the interest earned on the bond.
Back when it was still possible to use yield burning as a way to circumvent securities regulations, it was not unusual for insurers to work with municipalities to find a suitable haven for the extra profit generated by the practice. In some cases, the additional funds would be placed in a special account with an investment bank. At other times, the city might receive the funds as a separate payment as a donation to a city fund that was unrelated to the project at the heart of the bond issue.
Today, severe penalties apply when the practice is discovered. Penalties can include a wide range of options, from simple fines to imprisonment. Typically, most underwriters will not discuss the possibility of a yield reduction scheme, and municipalities that wish to operate well within the provisions of the law will take steps to ensure that nothing happens to the bond issue that could be construed mistakenly as a performance reduction.
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