What Is an Arbitrage Bond?

An arbitrage bond refers to the refinancing of a municipality's higher interest rate bond with a lower interest rate bond prior to the higher interest rate bond's call date.

Key Takeaways

  • An arbitrage bond is the refinancing of a municipality's higher interest rate bond with a lower interest rate bond prior to the higher interest rate bond's call date.
  • The strategy of issuing arbitrage bonds is particularly effective when prevailing interest rates and bond yields in the economy are declining.
  • The coupon rate on arbitrage bonds should be significantly below the coupon rate on the higher-interest bonds to make the arbitrage exercise worthwhile.

Understanding Arbitrage Bonds

An 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.

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 (arbitrage bonds), a practice called refunding, 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 which are then 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.

How an Arbitrage Bond Works

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 is 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.

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.