DEFINITION of 'Negative Arbitrage'

Negative arbitrage is the opportunity lost when municipal bond issuers assume proceeds from debt offerings and then invest that money for a period of time (ideally in a safe investment vehicle) until the money is used to fund a project, or to repay investors. The lost opportunity occurs when the money is reinvested and the debt issuer earns a rate or return that is lower than what must actually be paid back to the debt holders.

BREAKING DOWN 'Negative Arbitrage'

Negative arbitrage occurs when a borrower pays its debt at a higher interest rate than the rate the borrower earns on the money set aside to repay the debt. Basically, the borrowing cost is more than the lending cost. For example, to fund the construction of a highway, a state government issues $50 million in municipal bonds paying 6%. But while the offering is in process still, prevailing interest rates in the market drop. The proceeds from the bond issuance are invested in a money market account paying only 4.2% for a period of one year, because the prevailing market will not pay a higher rate. In this case, the issuer loses the equivalent of 1.8% interest that it could have earned or retained. The 1.8% results from negative arbitrage which is, in fact, an opportunity cost. The loss incurred by the city translates into less available funds for the highway project.

The concept of negative arbitrage can be explained with refunding bonds. If interest rates decrease below the coupon rate on existing callable bonds, an issuer is likely to pay off the bond and refinance its debt at the lower interest rate prevalent in the market. The proceeds from the new issue (the refunding bond) will be used to settle the interest and principal payment obligations of the outstanding issue (the refunded bond). However, due to the call protection placed on some bonds which prevents an issuer from redeeming the bonds for a period of time, proceeds from the new issue are used to purchase Treasury securities held in escrow. On the call date after the call protection elapses, the Treasuries are sold and the proceeds from the sale are used to retire the older bonds.

When the yield on the Treasury securities is below the yield on the refunding bonds, negative arbitrage occurs resulting from lost investment yield in the escrow fund. When there is negative arbitrage, the result is a significantly greater issue size and the feasibility of the advance refunding is often negated. When high interest rate bonds are advance refunded with low interest rate bonds, the amount of government securities required for the escrow account will be greater than the amount of outstanding bonds being refunded. To match the debt service of the higher interest payments of the  outstanding bonds with the lower interest of Treasuries, such as Treasury bills, the difference must be derived through more principal since the cash flow from the escrow must equal the cash flow on outstanding bonds to be refunded.

RELATED TERMS
  1. Refunded Bond

    Refunded bonds are bonds that have their principal cash amount ...
  2. Advance Refunding

    Advance refunding is when a bond issuance is used to pay off ...
  3. Municipal Bond Arbitrage

    Municipal bond arbitrage is building a leveraged portfolio of ...
  4. Escrowed To Maturity

    An escrowed to maturity bond has been repaid in advance via an ...
  5. Bond

    A bond is a fixed income investment in which an investor loans ...
  6. Double Barreled

    A double barreled bond is a municipal bond in which the interest ...
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

    Six biggest bond risks

    Bonds can be a great tool to generate income, but investors need to be aware of the pitfalls and risks of holding corporate and/or government securities.
  3. Investing

    Corporate Bond Basics: Learn to Invest

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

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
  5. 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.
  6. Retirement

    How to Pick the Right Bonds For Your IRA

    Learn about the best types of bonds to include in an IRA depending on an investor's risk tolerance. Understand the tax benefits of holding bonds in an IRA.
  7. Investing

    Find the Right Bond at the Right Time

    Learn about the types of bonds you should consider investing in, when you should be buying them and how to compare yields against their time to maturity.
  8. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  9. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
RELATED FAQS
  1. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
  2. What are the risks of investing in a bond?

    Are you thinking of investing in bond market? Learn more about bond market investment risk, including interest rate risk, ... Read Answer >>
Hot Definitions
  1. 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 ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  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. Diversification

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

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

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