DEFINITION of 'Arbitrage Bond'

A debt security with a lower interest rate issued by a municipality prior to the call date of the municipality's existing higher-rate security. Proceeds from the issuance of the lower-rate bonds are invested in treasuries until the call date of the higher-interest bonds.

Arbitrage bonds are used by municipalities when they wish to arbitrage the difference between current lower interest rates and bonds that they may have issued at higher coupon rates in the past. This strategy, which enables them to reduce the net effective cost of their borrowings, is particularly effective when interest rates and bond yields are declining.

BREAKING DOWN 'Arbitrage Bond'

The chief attraction of municipal bonds is their tax exemption feature. Arbitrage bonds may qualify for a temporary tax exemption as long as the proceeds from net sales and investments are to be used in future projects. If, however, the project experiences a significant delay or cancellation, the municipality may be taxed.

The coupon rate on arbitrage bonds should be significantly below the coupon rate on the higher-interest bonds to make the arbitrage exercise worthwhile. The impact of issuance and marketing costs for the potential new bond issue are also factored into the arbitrage decision.

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