DEFINITION of 'Arbitrage Bond'

Arbitrage bond is 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.

BREAKING DOWN 'Arbitrage Bond'

Arbitrage bonds are used by municipalities when they wish to arbitrage the difference between current lower interest rates in the market and higher coupon rates on existing bond issues. This strategy, which enables them to reduce the net effective cost of their borrowings, is particularly effective when prevailing interest rates and bond yields in the economy are declining.

Municipal bonds have an embedded call option, allowing the issuer to redeem its outstanding bonds prior to maturity and to refinance the bonds at a lower interest rate. The date on which the bond can be “called” or retired is referred to as the call date. The issuer cannot buy back the bonds until the call date. In the event that interest rates decline prior to the call date, the municipal authority may issue new bonds, called refunding or arbitrage bonds, with a coupon rate that reflects the lower going market rate. The proceeds from the new issue are used to purchase Treasury securities with a higher yield than the refunding bonds. The Treasuries are deposited in an escrow account. On the first call date of the outstanding higher-coupon bonds, the Treasuries are sold and used to redeem or refund the higher-coupon bonds.

Generally, the arbitrage involves purchasing U.S. Treasury bills that are used to pre-refund an outstanding issue prior to the outstanding issue's call date. The coupon rate on arbitrage bonds should be significantly below the coupon rate on the higher-interest bonds to make the arbitrage exercise worthwhile. Otherwise, the cost to issue the new bonds may be greater than the savings achieved by the refinancing and refunding process. The impact of issuance and marketing costs for the potential new bond issue are also factored into the arbitrage decision.

The chief attraction of municipal bonds is their tax exemption feature. However, only municipal bonds that are deemed to finance a project that benefits the community are tax-exempt. If refunding bonds are not used for community developments and are instead used to make a profit on yield differentials, the bonds will be considered arbitrage bonds and, thus, taxable. If the Internal Revenue Service (IRS) considers a refunding bond to be an arbitrage bond, the interest is included in each bondholder’s gross income for federal income tax purposes. However, the issuer may make payments to the IRS in return for the IRS not declaring the bonds taxable. 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. However, if the project experiences a significant delay or cancellation, the municipality may be taxed.

RELATED TERMS
  1. Negative Arbitrage

    Negative arbitrage is the opportunity lost when municipal bond ...
  2. Bond

    A bond is a fixed income investment in which an investor loans ...
  3. Refunding

    Refunding is the process of retiring or redeeming an outstanding ...
  4. Taxable Bond

    A taxable bond is a debt security whose return to the investor ...
  5. Bond Buyer 20

    Bond Buyer 20 is a representation of municipal bond trends based ...
  6. Municipal Bond Fund

    A municipal bond fund is a fund that invests in municipal bonds.
Related Articles
  1. Investing

    The Basics Of Municipal Bonds

    Investing in municipal bonds may offer a tax-free income stream, but such bonds are not without risks. Check out types of bonds and the risk factors of muni-bond.
  2. Investing

    Why Muni Bonds and Bond Funds are Perfect Together

    Municipal bonds and bond funds differ in several ways, which is partly why they complement each other well.
  3. 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.
  4. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  5. 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.
  6. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  7. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
  8. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
RELATED FAQS
  1. Where can I buy government bonds?

    The type of bond dictates its purchase. Federal bonds are issued by the federal government, while municipal bonds are issued ... Read Answer >>
  2. How are municipal bonds taxed?

    Discover information about the various tax implications for municipal bonds and zero-coupon municipal bonds at the state ... Read Answer >>
Trading Center