In the case of government-issued debt, arbitrage occurs when a government issues bonds at one rate of interest, and invests the proceeds at a higher rate of interest. The resulting gain is referred to as arbitrage earnings.
Advantages
Disadvantages
Arbitrage in the municipal bond market is the difference in the interest paid on an issuer's tax- exempt bonds and the interest earned by investing the bond proceeds in taxable securities. Proceeds from a bond issue are usually put into short-term investments until either they are spent on their intended use or, in the case of a refunding issue, used to call the original bonds. Both of these situations can generate arbitrage earnings. If interest rates on the investments are below the interest rates on the bonds, then there is "negative arbitrage."
During the 1980s, the federal government became concerned that municipal governments were abusing their power to issue bonds by issuing bonds unnecessarily in order to try to earn arbitrage. The 1986 Tax Reform Act put into place a variety of restrictions and regulations designed to prevent abuse. Several of the major restrictions are discussed below.
Federal arbitrage rules state that an issuer cannot invest tax-exempt bond proceeds at a higher yield than the interest rate on the bond issue, except in specific circumstances. More accurately, the yield on the investments can only be 1/8 of 1% higher, or arbitrage restrictions apply.
For example, if the yield on the refunding bond is 6%, the issuer is limited to a 6.125% return on the investment of the bond proceeds. The issuer can purchase special low-yield U.S. Treasury securities called the state and local government series to meet this requirement if the normal market instruments are paying more. However, there are exceptions to the yield restriction.
Arbitrage may be earned for certain temporary periods if the bond proceeds are used for certain kinds of projects and spent within specified periods of time. At the end of the permitted temporary period, the issuer must restrict the yield on the remaining proceeds.
Sometimes the issuer does earn prohibited arbitrage that had not been foreseen. If this happens, any earnings in excess of the bond yield must be returned to the U.S. Treasury in a process called "rebating." There are two possible penalties for an issuer who fails to comply with rebate requirements -- the IRS can declare the bonds taxable retroactive to the date of issue, or the IRS can assess a monetary penalty.
Another regulation limits advance refundings to once for each original bond issue. This limit prevents governments from repeatedly refunding the same issue each time interest rates drop in an attempt to realize even greater arbitrage earnings. Issuers must therefore carefully choose the timing of an advanced refunding. Also, private activity bonds cannot be advance refunded at all. This restriction prevents the federal subsidization, through tax-exempt arbitrage earnings, of private activities.
| Back To Topics | To Previous Section: Competitive Bid and Negotiated Sale |