Arbitrage Bonds: Understanding, Issuing, and Navigating the Pros and Cons

Arbitrage bonds represent a financial maneuver where a municipality strategically refinances its higher-interest bond with a lower-interest alternative prior to the higher-interest bond’s call date.

An arbitrage bond is essentially a debt security with a lower interest rate issued by a municipality before the call date of its existing higher-rate security. The underlying strategy involves taking advantage of the differential between current lower interest rates in the market and the higher coupon rates on existing bond issues. This tactical approach proves particularly effective in economic scenarios where interest rates and bond yields are on a declining trajectory.

Arbitrage bonds come into play when municipal authorities decide to refinance higher-interest bonds with lower-interest ones. The proceeds generated from the issuance of the lower-rate bonds are judiciously invested in U.S. Treasuries, and this investment strategy continues until the call date of the higher-interest bonds.

Municipal bonds inherently have an embedded call option, enabling the issuer to redeem outstanding bonds before maturity and refinance them at a more favorable, lower interest rate. This call option can only be exercised on the specified call date, restricting the issuer from buying back the bonds before this predetermined time.

Should interest rates decrease before the call date, the municipality may engage in the issuance of new bonds, commonly referred to as arbitrage bonds. This process, known as refunding, involves issuing new bonds with a coupon rate reflecting the lower prevailing market rate. The funds raised from this new issuance are then used to purchase Treasury securities with a yield higher than the refunding bonds. These Treasuries are placed in an escrow account. On the first call date of the existing higher-coupon bonds, the Treasuries are liquidated and the proceeds are utilized to redeem or refund the higher-coupon bonds.

Typically, the arbitrage process entails purchasing U.S. Treasury bills to pre-refund an outstanding issue before its call date. A critical condition for the success of this strategy is that the coupon rate on arbitrage bonds must be significantly lower than the coupon rate on the higher-interest bonds. This is paramount to ensure that the savings achieved through the refinancing and refunding process exceed the costs associated with issuing the new bonds. Additionally, the impact of issuance and marketing costs for the potential new bond issue is factored into the arbitrage decision.

One of the primary attractions of municipal bonds lies in their tax exemption feature. However, this tax exemption is contingent upon the municipal bonds being used to finance projects that benefit the community. If refunding bonds are utilized for purposes other than community development and instead employed to capitalize on yield differentials, they may be classified as arbitrage bonds and thus become taxable. The Internal Revenue Service (IRS) plays a crucial role in determining the tax status of refunding bonds. If the IRS deems a refunding bond to be an arbitrage bond, the interest earned is included in each bondholder’s gross income for federal income tax purposes.

In certain scenarios, the issuer may choose to make payments to the IRS in return for the IRS not declaring the bonds taxable. Arbitrage bonds may also qualify for a temporary tax exemption, provided the proceeds from net sales and investments are earmarked for future projects. However, if the planned projects encounter significant delays or are canceled, the municipality may become subject to taxation.

The primary objective of issuing arbitrage bonds is for municipalities to strategically refinance their existing higher-interest bonds with lower-interest alternatives, thereby reducing the net effective cost of their borrowings.

The Internal Revenue Service (IRS) assesses the tax status of refunding bonds, and if it deems them to be arbitrage bonds, the interest earned is included in each bondholder’s gross income for federal income tax purposes.

Arbitrage bonds may qualify for a temporary tax exemption if the proceeds from net sales and investments are designated for future projects. However, if these projects experience significant delays or are canceled, the municipality may become subject to taxation.