Municipal Bond Arbitrage


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.

BREAKING DOWN '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.

  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 ...
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  1. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. 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 >>

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