Yield burning involved inflating bond markups to circumvent US federal law on interest income for municipalities. Underwriters would find ways to shelter the extra profit. The practice is now illegal and carries stiff penalties.
Yield burning is a practice that has long been deemed unethical and was eventually outlawed. The procedure for burning yields involved placing inflated markups on the bonds used to complement some forms of municipal bond offerings. This drive up the price of the bonds would drive down the yield, creating a situation called burn.
The idea behind the practice was to circumvent 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 bond issue, the municipality is prohibited from making more money in interest than it pays on the debt. By engaging in bond markups, it is possible for the underwriter of the bond to still make additional income from the project without affecting the interest earned on the bond.
When yield burning was still possible to use as a way to circumvent securities regulations, it was not uncommon for underwriters to work with municipalities to find a suitable shelter for the extra profit generated by the practice. In some cases, the additional funds would be deposited into a special account at an investment bank. Other times, the city may receive the funds as a separate payment as a donation to a city fund unrelated to the project at the heart of the loan issuance.
Today there are stiff penalties when the practice is discovered. Sanctions can include a wide range of options, from simple fines to imprisonment. Generally, most underwriters will not discuss the possibility of a yield burn-in scheme and municipalities who wish to do well with the statutory provisions will take steps to ensure that nothing can happen with the bond issuance that could be misinterpreted like a yield burn.
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