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.

RELATED TERMS
  1. Municipal Bond

    A debt security issued by a state, municipality or county to ...
  2. Taxable Municipal Bond

    A fixed-income security issued by a local government such as ...
  3. Fully Taxable Equivalent Yield

    The yield on a municipal bond, when the effect of reduced taxes ...
  4. Municipal Bond Fund

    A mutual fund that invests in municipal bonds, or "munis." Municipal ...
  5. Rate Anticipation Swap

    A type of swap in which bonds are exchanged according to their ...
  6. Triple-Tax-Free

    An investment (usually a municipal bond) featuring interest payments ...
Related Articles
  1. Investing

    Do Municipal Bond Mutual Funds Offer a Tax Incentive?

    Learn about individual municipal securities and municipal bond funds, whose principal stability and tax-free yield appeal to high-income investors.
  2. Investing

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  3. Financial Advisor

    Muni Bonds, Taxable Bonds or CDs: Which is Best?

    Here's how to tell if municipal bonds are a better investment than taxable bonds or CDs.
  4. Investing

    The Top 5 Municipal Bond Funds for 2016

    Understand how the addition of municipal bond mutual funds can enhance a portfolio, and learn the top-rated municipal bond funds to consider for 2016.
  5. Investing

    The Top 5 Municipal Bond ETFs for 2016

    Learn about exchange-traded funds that invest in municipal bonds issued by local U.S. municipalities with returns on bonds exempted from federal tax.
  6. Investing

    The Basics Of Municipal Bonds

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

    Think Twice Before Buying Tax-Free Municipal Bonds

    Municipal bonds are relatively safe, tax-exempt securities--but they are not without drawbacks. Due diligence is required.
  8. Investing

    Should You Consider Muni Bonds?

    Municipal bonds come in two types. General obligation bonds repay their holders through taxes. They often have low interest rates, but they’re safe.
  9. Investing

    Taxation Rules for Bond Investors

    Several factors affect the taxable interest that must be reported. Learn more here.
  10. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
RELATED FAQS
  1. How do the returns on municipal bonds compare to those of other bonds?

    Learn how tax-free municipal bonds may provide better returns than other types of bonds, and understand the risks of municipal ... Read Answer >>
  2. What do cities do with the funds generated from municipal bonds?

    Learn more about municipal bonds, including the various types of bonds issued and the purposes of municipal bond funds, such ... Read Answer >>
  3. How are municipal bonds taxed?

    Discover information about trading municipal bonds, specifically the various tax implications municipal bonds have at state ... Read Answer >>
  4. What is a triple tax-free municipal bond?

    At its core, a triple tax-free municipal bond is just like any corporate bond: it is a debt instrument, a loan given to a ... Read Answer >>
  5. What is the difference between municipal bonds and standard money market funds?

    The primary difference between municipal bonds - also known as "munis" - and money market funds is that municipal bonds are ... Read Answer >>
  6. Who or what is backing municipal bonds?

    Learn about the basics of municipal bonds, including the various revenue sources that are utilized to back or secure municipal ... Read Answer >>
Hot Definitions
  1. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  2. Pro Forma

    A Latin term meaning "for the sake of form". In the investing world, it describes a method of calculating financial results ...
  3. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
  4. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  5. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta by investing in securities that differ from the market index ...
  6. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
Trading Center