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. Taxable Municipal Bond

    A fixed-income security issued by a local government such as ...
  2. Triple-Tax-Free

    An investment (usually a municipal bond) featuring interest payments ...
  3. Zero Basis Risk Swap - ZEBRA

    A swap agreement between a municipality and a financial intermediary. ...
  4. Net Debt To Assessed Valuation

    In a municipal bond issue, a ratio measuring the value of the ...
  5. Unlimited Tax Bond

    A municipal bond that is backed by the pledge of the issuer (generally ...
  6. Bond Swap

    Selling one debt instrument in order to use the proceeds to purchase ...
Related Articles
  1. Investing

    Municipal Bonds Vs. Money Market Funds

    Municipal bonds are a loan from you to a state or local government or authority; money market funds are a type of mutual fund.
  2. Investing

    The Basics Of Municipal Bonds

    Investing in municipal bonds may offer a tax-free income stream, but such bonds are not without risks.
  3. 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.
  4. 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.
  5. Investing

    Taxation rules for bond investors

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

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  7. 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.
  8. Investing

    5 Popular Municipal Bond ETFs in 2016 (MUB, SHM)

    Learn how the five most popular national municipal bond ETFs can generate income that is exempt from state taxes, as well as AMT in certain circumstances.
  9. Investing

    Muni Bond ETFs to Date 2016 Performance Review (MUB, XMPT)

    Learn how municipal bond exchange-traded funds have performed year-to-date in 2016, and which ones have performed the best and the worst so far.
  10. Investing

    What's a Tax-Efficient Investment for a Large Sum?

    Here's how to invest a large sum, such as assets from a profit-sharing plan, with a mind toward tax efficiency.
RELATED FAQS
  1. 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 >>
  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 >>
  3. How can you use a debt service coverage ratio (DSCR) to evaluate municipal bonds?

    Learn how the debt service coverage ratio (DSCR) can be used by investors to analyze the risk level of revenue bonds offered ... Read Answer >>
Hot Definitions
  1. Swap

    A swap is a derivative contract through which two parties exchange financial instruments, such as interest rates, commodities, ...
  2. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Risk Tolerance

    The degree of variability in investment returns that an individual is willing to withstand. Risk tolerance is an important ...
  5. Donchian Channels

    A moving average indicator developed by Richard Donchian. It plots the highest high and lowest low over the last period time ...
  6. Consumer Price Index - CPI

    A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, ...
Trading Center