Definition
An arbitrage bond is a bond issued by a municipality to achieve an interest rate advantage by refunding higher-rate bonds before their call date. The proceeds from the lower-rate refunding issue are invested in higher-yielding treasuries until the first call date of the higher-rate issue being refunded. This financial strategy aims to reduce the overall cost of the debt over time.
Examples
Example 1: City of Springfield
The City of Springfield has outstanding bonds with an interest rate of 6%, which are callable in five years. Currently, the market interest rate is 4%. To benefit from the lower rate, Springfield issues new bonds at 4% and invests the proceeds in treasuries yielding 5% until the original bonds can be called and refunded.
Example 2: County of Riverside
Riverside County holds bonds with a 5.5% rate due in eight years, but the current interest rate environment offers bonds at 3.5%. The county issues new bonds at this lower rate, with the proceeds invested in treasuries yielding 4% until the call date of the higher-rate bonds.
Frequently Asked Questions (FAQs)
What is the primary purpose of issuing an arbitrage bond?
The primary purpose is to take advantage of lower-market interest rates to reduce overall debt costs by refunding higher-rate bonds in advance of their call date.
Can any municipality issue an arbitrage bond?
Yes, any municipality can issue an arbitrage bond, provided they comply with federal tax laws and regulations governing municipal bonds.
What are the risks associated with arbitrage bonds?
The primary risks are interest rate risk, market risk, and regulatory risk. If interest rates rise, the arbitrage opportunity might be less beneficial or result in losses.
Are there any legal constraints on issuing arbitrage bonds?
Yes, federal tax laws place constraints on the issuance of arbitrage bonds to prevent excessive arbitrage profits, including limits on permissible yields and financing restrictions.
How are arbitrage bond proceeds invested?
Proceeds are typically invested in higher-yielding treasury securities or other secure financial instruments until the call date of the higher-rate bonds being refunded.
Refunding Bond
A bond issued to refinance an existing bond issue, typically to reduce interest costs.
Call Date
The date on which a bond can be redeemed before its maturity date.
Treasuries
Debt securities issued by the government, deemed stable investments with lower default risk.
Yield
The income return on an investment, such as the interest or dividends received.
Municipal Bond
A debt security issued by a state, municipality, or county to finance its capital expenditures, such as constructing highways, schools, or other infrastructure.
Online References
- Investopedia: Arbitrage Bond
- U.S. Securities and Exchange Commission
Suggested Books for Further Studies
- Handbook of Municipal Bonds by Sylvan G. Feldstein and Frank J. Fabozzi
- The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More by Annette Thau
- Municipal Bonds: The Basics and Beyond by Paul A. Burton
Fundamentals of Arbitrage Bond: Finance Basics Quiz
### What is the main reason for issuing an arbitrage bond?
- [x] To take advantage of lower market interest rates.
- [ ] To diversify the city's investment portfolio.
- [ ] To fund new municipal projects.
- [ ] To increase the municipality's liquidity.
> **Explanation:** The primary reason for issuing an arbitrage bond is to benefit from lower-market interest rates by refunding higher-rate bonds in advance of their call date.
### What is typically done with the proceeds from an arbitrage bond issuance?
- [ ] Used to pay off old debts immediately.
- [x] Invested in higher-yielding treasuries until the call date of the higher-rate bonds.
- [ ] Distributed to municipal employees as bonuses.
- [ ] Used for immediate infrastructure projects.
> **Explanation:** The proceeds from an arbitrage bond issuance are usually invested in higher-yielding treasuries or other secure investments until the call date of the higher-rate bonds being refunded.
### Can an arbitrage bond be issued by private corporations?
- [ ] Yes, but only large corporations.
- [x] No, they are typically issued by municipalities.
- [ ] Yes, any company can issue them.
- [ ] Only companies with a high credit rating.
> **Explanation:** Arbitrage bonds are typically issued by municipalities, not private corporations, to achieve a lower interest rate on their debt.
### Which of the following is a risk associated with arbitrage bonds?
- [ ] Currency risk
- [ ] Political risk
- [x] Interest rate risk
- [ ] Credit risk of the issuing municipality
> **Explanation:** Interest rate risk is a significant concern for arbitrage bonds, as changes in interest rates can affect the profitability of the arbitrage strategy.
### What regulates the issuance of arbitrage bonds to prevent excessive arbitrage profits?
- [ ] State laws only
- [x] Federal tax laws
- [ ] Municipal charters
- [ ] Internal municipal policies
> **Explanation:** Federal tax laws regulate the issuance of arbitrage bonds to prevent municipalities from generating excessive arbitrage profits.
### What is a 'call date' in the context of arbitrage bonds?
- [ ] The date when the bond was issued.
- [x] The date when the bond can be redeemed before its maturity.
- [ ] The date interest payments are first made.
- [ ] The final maturity date of the bond.
> **Explanation:** The call date is the date when a bond can be redeemed before its maturity date.
### What happens if interest rates rise after an arbitrage bond is issued?
- [ ] The municipality profits more.
- [ ] The bond immediately defaults.
- [ ] The bond yields higher interest.
- [x] The arbitrage opportunity might become less beneficial or result in losses.
> **Explanation:** If interest rates rise, the arbitrage opportunity might be less beneficial, leading to potential financial losses or reduced savings.
### Which book is recommended for learning more about municipal bonds and arbitrage?
- [ ] "The Intelligent Investor" by Benjamin Graham
- [ ] "Principles of Economics" by Karl E. Case
- [x] "Handbook of Municipal Bonds" by Sylvan G. Feldstein and Frank J. Fabozzi
- [ ] "Security Analysis" by Benjamin Graham and David Dodd
> **Explanation:** "Handbook of Municipal Bonds" by Sylvan G. Feldstein and Frank J. Fabozzi is a recommended book for learning more about municipal bonds and arbitrage strategies.
### What is a treasuries security in the context of arbitrage bonds?
- [ ] A stock issued by private corporations.
- [ ] A type of municipal bond.
- [x] Debt securities issued by the government.
- [ ] Certificates issued by private banks.
> **Explanation:** Treasuries are debt securities issued by the government and are typically used as secure investment vehicles for arbitrage bond proceeds.
### How does an arbitrage bond reduce overall debt costs?
- [ ] By increasing the municipality's credit rating.
- [x] By issuing bonds at a lower interest rate and investing proceeds in higher-yielding treasuries.
- [ ] By immediately paying off all old debts.
- [ ] By extending the maturity date of the bonds.
> **Explanation:** An arbitrage bond reduces overall debt costs by issuing new bonds at a lower interest rate and investing the proceeds in higher-yielding treasuries until the refunding date.
Thank you for exploring the concept of arbitrage bonds and testing your knowledge through our comprehensive quiz. Keep striving for financial literacy and make informed investment decisions!
