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.

RELATED TERMS
  1. Municipal Bond Arbitrage

    A strategy that consists of building a portfolio of tax-exempt ...
  2. Net Debt To Estimated Valuation

    A ratio comparing the net value of a municipal bond issue to ...
  3. Net Debt To Assessed Valuation

    In a municipal bond issue, a ratio measuring the value of the ...
  4. Taxable Municipal Bond

    A fixed-income security issued by a local government such as ...
  5. Private Purpose Bond

    A type of municipal bond that is issued to finance a project ...
  6. Unlimited Tax Bond

    A municipal bond that is backed by the pledge of the issuer (generally ...
Related Articles
  1. 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.
  2. Investing

    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.
  3. 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.
  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. Financial Advisor

    How to Find the Best Bets in Muni Bonds

    Approach investing in municipal bonds the same as you would investing in stocks.
  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. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  9. Investing

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. How are municipal bonds taxed?

    Discover information about trading municipal bonds, specifically the various tax implications municipal bonds have at state ... Read Answer >>
Hot Definitions
  1. Asset Allocation

    An investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's ...
  2. IRR Rule

    A measure for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of ...
  3. Short Covering

    Short covering is buying back borrowed securities in order to close an open short position.
  4. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  5. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  6. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
Trading Center