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.
Related Terms
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
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
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