What is 'Municipal Bond Arbitrage'

Municipal bond arbitrage involves building a leveraged portfolio of tax-exempt municipal bonds and simultaneously hedging the duration risk of the portfolio. The hedging takes place through the short sale of equivalent taxable corporate bonds of the same maturity, generally via interest rate swaps.

Municipal bond arbitrage is also commonly referred to as municipal bond relative value arbitrage, municipal arbitrage or just muni arb.

BREAKING DOWN 'Municipal Bond Arbitrage'

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.

Because interest on municipal bonds is 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, 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, 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.

  1. Arbitrage Bond

    Arbitrage bond is a debt security with a lower interest rate ...
  2. Municipal Bond

    A municipal bond is a debt security issued by a state, municipality ...
  3. Municipal Bond Fund

    A municipal bond fund is a fund that invests in municipal bonds.
  4. Obligation Bond

    A municipal bond whose face value of the bond is greater than ...
  5. Tax-Exempt Sector

    The tax-exempt sector is a market niche comprised of investment ...
  6. Fixed-Income Arbitrage

    Fixed income arbitrage is an investment strategy that realizes ...
Related Articles
  1. Investing

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  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. Check out types of bonds and the risk factors of muni-bond.
  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

    Consider These Municipal Bond ETFs

    Though relatively low-risk, there are still some factors to consider when taking the plunge into municipal bond ETFs.
  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

    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.
  7. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  8. 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.
  9. Investing

    Foreign Investors Flock to U.S. Municipal Bonds

    Interest in U.S. municipal bonds by foreign investors is on the rise. Here's why.
  1. What Is a Triple Tax-Free Municipal Bond?

    Learn how a triple tax-free municipal bond is like any corporate bond, but provides an additional incentive for investors ... 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 >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center