Negative Arbitrage

What Is Negative Arbitrage?

Negative arbitrage is the opportunity lost when bond issuers expect proceeds from debt offerings and afterward hold that money in escrow for a while (generally in cash or short-term treasury investments) until the money can be put to use to fund a project, or to repay investors. Negative arbitrage might happen with another bond issue or following a debt refinancing.

The opportunity cost happens when the money is reinvested and the debt issuer earns a rate or return that is lower than what must really be paid back to debt holders.

How Negative Arbitrage Works

Negative arbitrage happens when a borrower pays off its debts at a higher interest rate than the rate the borrower earns on the money set to the side to repay the debt. Basically, the borrowing cost is more than the lending cost.

For instance, to fund the construction of a highway, a state government issues $50 million in municipal bonds paying 6%. However, while the offering is still in process, winning interest rates in the market fall. The proceeds from the bond issuance are hence invested in a money market account paying just 4.2% for a period of one year, in light of the fact that the common market won't pay a higher rate. In this case, the issuer loses the equivalent of 1.8% interest that it might have earned or retained. The 1.8% outcomes from negative arbitrage which is, as a matter of fact, an opportunity cost. The loss incurred by the state converts into less available funds for the highway project for its residents.

Negative Arbitrage and Refunding Bonds

The concept of negative arbitrage can be shown utilizing the case of refunding bonds. Assuming interest rates decline below the coupon rate on existing callable bonds, an issuer is probably going to pay off the bond and refinance its debt at the lower interest rate predominant in the market. The proceeds from the new issue (the refunding bond) will be utilized to settle the interest and principal payment obligations of the outstanding issue (the refunded bond). Nonetheless, due to the call protection put on certain bonds which keeps an issuer from recovering the bonds for a while, proceeds from the new issue are utilized to purchase Treasury securities held in escrow. On the call date after the call protection passes, the Treasuries are sold and the proceeds from the sale are utilized to retire the more seasoned bonds.

When the yield on the Treasury securities is below the yield on the refunding bonds, negative arbitrage happens coming about because of lost investment yield in the escrow fund. At the point when there is negative arbitrage, the outcome is a fundamentally greater issue size and the feasibility of the advance refunding is frequently discredited. At the point 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, for example, Treasury bills, the difference must be derived through additional principal since the cash flow from the escrow must approach the cash flow on outstanding bonds to be refunded.

Highlights

• Negative arbitrage is an opportunity cost lost to holding debt proceeds in escrow until a project can really be funded.
• The negative arbitrage cost is basically the difference in the borrower's net cost to creditors less what it can earn on utilizing those proceeds to borrow again.
• Negative arbitrage happens on the off chance that predominant interest rates fall during this period of time, which can last from several days to years.
• Callable and refunded bonds demonstrate ways that issuers can safeguard against negative arbitrage.