Yield burning is a practice that has long been held to be unethical and eventually was declared illegal. The procedure for yield burning involved placing inflated markups on bonds that were used to complete some forms of municipal bond offerings. This action of marking up the price of the bonds would cause the yield to fall, creating a situation referred to as a burn.
The idea behind the practice was to get around certain aspects of United States federal law that have to do with the amount of interest income that a municipality could earn on Treasury securities. Under the terms and conditions of the issue of the securities, the municipality is prohibited from making more money in interest than is paid on the debt. By engaging in bond markups, it is possible for the underwriter for the bond to still realize additional revenue from the project without impacting the interest earned from the bond.
When it was still possible to use yield burning as a way to circumvent securities regulations, it was not unusual for underwriters to work with municipalities to find a proper shelter 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 municipality 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, stiff penalties are in place when the practice is uncovered. The penalties may include a wide range of options, from simple fines all the way through imprisonment. Typically, most underwriters will not discuss the possibility of a yield burning scheme, and municipalities that wish to operate well with the provisions of the law will take steps to ensure nothing can occur with the bond issue that can be misconstrued as a yield burning.
