Municipal Bond Arbitrage
What is Municipal Bond Arbitrage?
Municipal bond arbitrage alludes to the strategy that an investor conveys where they leverage the tax-exempt status of municipal bonds to hedge their portfolio's duration risk.
Understanding Municipal Bond Arbitrage
Municipal bond arbitrage includes hedging a portfolio of tax-exempt municipal bonds by all the while shorting equivalent taxable corporate bonds of a similar maturity. Municipal bond arbitrage is additionally normally alluded to as municipal bond relative value arbitrage, municipal arbitrage or just "muni-arb".
Duration risk is the risk that an investor, particularly a bondholder, faces from changes in interest rates that may negatively influence the market value of their fixed-income investments. The municipal bond arbitrage strategy expects to limit credit and duration risk by utilizing municipal bonds and interest rate swaps of comparable quality and maturity. The implicit assumption in this method is the municipal bonds, and interest rate swaps will keep on having a close correlation.
Since interest payments from municipal bonds are exempt from federal income tax, a 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 a particularly appealing option for certain investors in major league salary tax brackets. Arbitrage opportunities are much of the time considered okay since they generally include very little or no negative cash flow.
For example, municipal bondholders will frequently purchase a portfolio of tax-exempt, top notch municipal bonds. Simultaneously, they will sell an assortment of equivalent taxable corporate bonds to profit from the tax rate. Positive, tax-free returns from municipal bond arbitrage can venture into the double digits.
Ascertaining municipal bond arbitrage requires various complex factors and calculations. Calculations incorporate deciding the genuine yield on a municipal bond issue and computing the true suitable earnings utilizing this real yield. The investor would then utilize future value estimations on the difference between the investment earnings receipt date and the calculation date.
Municipal Bond Arbitrage Compliance
Tax-exempt municipal bond issuers are subject to severe federal arbitrage compliance rules as a condition of issuance requirements, for example, bond covenants. Any processed profits, which are called rebates, must be paid to the federal government. Federal arbitrage rules are intended to forestall issuers of tax-exempt bond debt from getting extreme or premature debt and accordingly profiting from the investment of bond proceeds in income-creating investments.
Federal income tax laws limit the ability to earn arbitrage regarding tax-exempt bonds or other federally tax-advantaged bonds. Arbitrage must be carefully calculated and reported to conform to a potential IRS arbitrage rebate exam. Profits must be reported on IRS Form 8038-T and must be documented somewhere around once like clockwork. Inability to follow these requirements might bring about financial punishments or the loss of the bonds' tax-exempt status.
Features
- Municipal bond arbitrage alludes to the strategy that an investor sends where they leverage the tax-exempt status of municipal bonds to hedge their portfolio's duration risk.
- Municipal bond arbitrage strategies can be a particularly appealing option for certain investors in major league salary tax brackets.
- Municipal bond arbitrage includes hedging a portfolio of tax-exempt municipal bonds by all the while shorting equivalent taxable corporate bonds of a similar maturity.
