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-Exempt Security

    A security in which the income produced is free from federal, ...
  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 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

    How Swaptions Can Reduce Risk in Portfolios

    How can investing in Swaptions reduce risk in portfolios.
  4. Stock Analysis

    Find The Right Discount Rate Amid Post-2007 Risks

    OIS discounting has become part of standard valuation techniques, in a market in which there is more uncertainty and less proxies for the risk-free rate.
  5. Trading Strategies

    How To Arbitrage Precious Metals

    Here are the fine points, trading tips, suitable securities, and examples for precious metal arbitrage trading.
  6. Investing

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  7. Brokers

    Arbitrage Opportunities in Spread Betting

    While the opportunities are few and far between, investors may use arbitrage to take advantage of price differences in financial spread betting.
  8. Investing Basics

    CDs or Bonds: Which Investment is Better For You

    When choosing between CDs and bonds, investors who seek to maximize their returns but also want a large measure of safety should consider the following:
  9. Bonds & Fixed Income

    Interested In West African Debt? Look Here First

    Promising high yields that the Eurozone and U.S. can't match, West African sovereign debt has caught the attention of savvy investors.
  10. Investing Basics

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.

You May Also Like

Hot Definitions
  1. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  2. Fixed-Charge Coverage Ratio

    A ratio that indicates a firm's ability to satisfy fixed financing expenses, such as interest and leases. It is calculated ...
  3. Efficiency Ratio

    Ratios that are typically used to analyze how well a company uses its assets and liabilities internally. Efficiency Ratios ...
  4. Fixed Cost

    A cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses ...
  5. Subsidy

    A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy ...
  6. Sunk Cost

    A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business ...
Trading Center