Municipal Bond Arbitrage

AAA

DEFINITION of 'Municipal Bond Arbitrage'

A strategy that consists of building a portfolio of tax-exempt municipal bonds and simultaneously hedging the duration risk of the portfolio through the short sale of equivalent taxable corporate bonds of the same maturity, generally interest rate swaps. Because interest on municipal bonds is exempt from federal income tax, an arbitrageur can receive after-tax income from the municipal bond portfolio that is higher than the interest paid on the interest rate swap.

INVESTOPEDIA EXPLAINS 'Municipal Bond Arbitrage'

The implicit assumption in this arbitrage is that the municipal bonds and interest rate swaps will continue to have a close correlation. The strategy seeks to minimize credit risk and duration risk by using municipal bonds and interest rate swaps of similar quality and maturity.

RELATED TERMS
  1. Fully Taxable Equivalent Yield

    The yield on a municipal bond, when the effect of reduced taxes ...
  2. Maintenance Bond

    A type of surety bond purchased by a contractor that protects ...
  3. Interest Rate Swap

    An agreement between two parties (known as counterparties) where ...
  4. Tax-Equivalent Yield

    The pretax yield that a taxable bond needs to possess for its ...
  5. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  6. Municipal Bond

    A debt security issued by a state, municipality or county to ...
RELATED FAQS
  1. Is there a difference between financial spread betting and arbitrage?

    Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >>
  2. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  3. Who or what is backing municipal bonds?

    Municipal bonds are backed by dedicated taxes or revenue sources related to specific projects, or by the full faith and credit ... Read Full Answer >>
  4. How stable are municipal bonds?

    Stability is relative in the municipal bond market. Municipal bonds tend to be safer than many other types of investments, ... Read Full Answer >>
  5. What does it signify if the term structure of an interest rate's curve is positive?

    When the term structure of interest rates is positive, it is a signal to economists the short-term yields on similar bonds ... Read Full Answer >>
  6. What do cities do with the funds generated from municipal bonds?

    Funds generated from the sale of municipal bonds may go to provide for unspecified, general government financial needs, or ... Read Full Answer >>
Related Articles
  1. Bonds & Fixed Income

    The Basics Of Municipal Bonds

    Investing in these bonds may offer a tax-free income stream but they are not without risks.
  2. Taxes

    Avoid Tricky Tax Issues On Municipal Bonds

    Learn the rules every investor should know before buying into this "tax-free" investment.
  3. Investing

    4 Structured Product Types Wealthy Clients Love

    High-net-worth investors find structured products appealing for a variety of reasons. Here's a look at four types.
  4. Economics

    Sacrifices Necessary to Keep Puerto Rico Afloat

    After years of band aids and significant borrowing to meet its obligations, the time has come for meaningful reform in Puerto Rico.
  5. Mutual Funds & ETFs

    ETF Analysis: Vanguard Total Bond Market

    Learn about the Vanguard Total Bond Market exchange-traded fund, its primary portfolio holdings and risk/reward profile based on its past performance.
  6. Trading Systems & Software

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
  7. Mutual Funds & ETFs

    ETF Analysis: Direxion Daily 20 Year Treasury

    Read about one potent, yet volatile, way to bet on rising interest rates -- the Direxion Daily 20 Year Plus Treasury Bear 3X exchange-traded fund (TMV).
  8. Stock Analysis

    Top 5 Emerging Market Bond ETFs

    The high growth potential of emerging markets makes these five ETFs popular among risk-tolerant investors.
  9. Trading Systems & Software

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  10. Stock Analysis

    Playing Rising Rates with Ultra-Short Term Bonds

    With rising rates likely, investors may want to consider adding a dose of ultra-short bonds to their portfolios. Here are some ETFs to consider.

You May Also Like

Hot Definitions
  1. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  2. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
  3. Investopedia

    One of the best-known sources of financial information on the internet. Investopedia is a resource for investors, consumers ...
  4. Unfair Claims Practice

    The improper avoidance of a claim by an insurer or an attempt to reduce the size of the claim. By engaging in unfair claims ...
  5. Killer Bees

    An individual or firm that helps a company fend off a takeover attempt. A killer bee uses defensive strategies to keep an ...
  6. Sin Tax

    A state-sponsored tax that is added to products or services that are seen as vices, such as alcohol, tobacco and gambling. ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!