What Is an Arbitrage Bond?
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 utilized 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 empowers them to reduce the net effective cost of their borrowings, is especially effective while winning interest rates and bond yields in the economy are declining.
Municipal bonds have a embedded call option, permitting the issuer to recover 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 alluded to as the call date. The issuer can't buy back the bonds until the call date.
If interest rates decline prior to the call date, the municipal authority might issue new bonds (arbitrage bonds), a practice called refunding, with a coupon rate that mirrors the lower going market rate. The proceeds from the new issue are utilized to purchase Treasury securities with a higher yield than the refunding bonds which are then kept in a escrow account. On the first call date of the outstanding higher-coupon bonds, the Treasuries are sold and used to reclaim or refund the higher-coupon bonds.
How an Arbitrage Bond Works
By and large, the arbitrage includes purchasing U.S. Treasury bills that are utilized to pre-refund an outstanding issue prior to the outstanding issue's call date. The coupon rate on arbitrage bonds ought to be altogether below the coupon rate on the higher-interest bonds to make the arbitrage exercise advantageous. If not, the cost to issue the new bonds might be greater than the savings accomplished by the refinancing and refunding process. The impact of issuance and marketing costs for the potential new bond issue is likewise considered into the arbitrage decision.
The chief fascination of municipal bonds is their tax exemption feature. Nonetheless, just municipal bonds that are considered to finance a project that benefits the community are tax-exempt. In the event that refunding bonds are not utilized for community improvements and are rather used to create a gain on yield differentials, the bonds will be viewed as arbitrage bonds and in this way taxable. On the off chance that the Internal Revenue Service (IRS) considers a refunding bond to be an arbitrage bond, the interest is remembered for every bondholder's gross income for federal income tax purposes.
The issuer may make payments to the IRS in return for the IRS not proclaiming the bonds taxable. Arbitrage bonds might meet all requirements for an impermanent tax exemption as long as the proceeds from net sales and investments are to be utilized in later projects. Nonetheless, on the off chance that the project encounters a huge deferral or cancellation, the municipality might be taxed.
- The strategy of giving arbitrage bonds is especially effective while winning interest rates and bond yields in the economy are declining.
- 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 coupon rate on arbitrage bonds ought to be fundamentally below the coupon rate on the higher-interest bonds to make the arbitrage exercise advantageous.