What is Municipal Bond Arbitrage?

Municipal bond arbitrage refers to the strategy that an investor deploys where they leverage the tax-exempt status of municipal bonds to hedge their portfolio's duration risk.

Key Takeaways

  • Municipal bond arbitrage refers to the strategy that an investor deploys where they leverage the tax-exempt status of municipal bonds to hedge their portfolio's duration risk.
  • Municipal bond arbitrage involves hedging a portfolio of tax-exempt municipal bonds by simultaneously shorting equivalent taxable corporate bonds of the same maturity.
  • Municipal bond arbitrage strategies can be an especially attractive option for some investors in high-income tax brackets.

Understanding Municipal Bond Arbitrage

Municipal bond arbitrage involves hedging a portfolio of tax-exempt municipal bonds by simultaneously shorting equivalent taxable corporate bonds of the same maturity. Municipal bond arbitrage is also commonly referred to as municipal bond relative value arbitrage, municipal arbitrage or just "muni-arb".

Duration risk is the risk that an investor, especially a bondholder, faces from changes in interest rates that may negatively affect the market value of their fixed-income investments. The municipal bond arbitrage strategy aims to minimize credit and duration risk by using municipal bonds and interest rate swaps of similar quality and maturity. The implicit assumption in this method is the municipal bonds, and interest rate swaps will continue to have a close correlation.

Since interest payments from municipal bonds are exempt from federal income tax, an arbitrageur can receive after-tax income from the municipal bond portfolio which is higher than the interest paid on the interest rate swap. This strategy can be an especially attractive option for some investors in high-income tax brackets. Arbitrage opportunities are often considered low-risk because they generally involve very little or no negative cash flow.

For example, municipal bondholders will often purchase a portfolio of tax-exempt, high-quality municipal bonds. At the same time, they will sell a collection of equivalent taxable corporate bonds to profit from the tax rate. Positive, tax-free returns from municipal bond arbitrage can reach into the double digits.

Calculating municipal bond arbitrage requires numerous complex factors and computations. Computations include determining the actual yield on a municipal bond issue and calculating the true allowable earnings using this actual yield. The investor would then use future value calculations on the difference between the investment earnings receipt date and the computation date.

Municipal Bond Arbitrage Compliance

Tax-exempt municipal bond issuers are subject to strict federal arbitrage compliance rules as a condition of issuance requirements, such as bond covenants. Any computed profits, which are called rebates, must be paid to the federal government. Federal arbitrage rules are designed to prevent issuers of tax-exempt bond debt from obtaining excessive or premature debt and therefore profiting from the investment of bond proceeds in income-generating investments.

Federal income tax laws limit the ability to earn arbitrage in connection with tax-exempt bonds or other federally tax-advantaged bonds. Arbitrage must be carefully calculated and documented to comply with a potential IRS arbitrage rebate exam. Profits must be reported on IRS Form 8038-T and must be filed at least once every five years. Failure to comply with these requirements may result in financial penalties or the loss of the bonds’ tax-exempt status.