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Municipal Bond Arbitrage Definition

What is Municipal Bond Arbitration?

Municipal bond arbitrage refers to the strategy an investor deploys when taking advantage of the tax-exempt status of municipal bonds to cover their portfolio duration risk.

Key points to remember

  • Municipal bond arbitrage refers to the strategy an investor deploys when taking advantage of the tax-exempt status of municipal bonds to hedge the duration risk of their portfolio.
  • Municipal bond arbitrage involves hedging a portfolio of tax-exempt municipal bonds by simultaneously shorting equivalent taxable corporate bonds of the same maturity.
  • Municipal bond arbitrage strategies can be a particularly attractive option for some investors in high-income tax brackets.

Understanding Municipal Bond Arbitrage

Municipal bond arbitrage involves hedging a portfolio of tax-exempt municipal bonds by short circuit equivalent taxable corporate bonds of the same maturity. Municipal bond arbitration is also commonly referred to as municipal bond relative value arbitration, municipal arbitration, or simply “muni-arb”.

Duration risk is the risk that an investor, particularly a bondface changes in interest rates that may adversely affect the market value of their fixed income investments. The municipal bond arbitrage strategy aims to minimize credit and duration risk by using municipal bonds and interest rate swaps of similar quality and maturity. The implicit assumption in this method is municipal bonds, and interest rate swaps will continue to have a close correlation.

Since interest payments on municipal bonds are exempt from federal income tax, a arbitrator may receive after-tax income from the municipal bond portfolio that is greater than the interest paid on the interest rate swap. This strategy may be a particularly attractive option for some investors in higher income tax brackets. Arbitrage opportunities are often considered low risk because they typically involve very little or no negative cash flow.

For example, municipal bondholders often purchase a portfolio of high-quality, tax-exempt municipal bonds. At the same time, they will sell a collection of equivalent taxable corporate bonds to take advantage of the tax rate. Positive, tax-free returns from municipal bond arbitrage can reach into the double digits.

Calculating municipal bond arbitrage requires many complex factors and calculations. Calculations include real value determination yield on a municipal bond issue and calculating the true qualifying income using that true yield. The investor would then use future value calculations on the difference between the date of receipt of investment income and the calculation date.

Municipal Bond Arbitration Compliance

Tax-exempt municipal bond issuers are subject to strict federal compliance arbitration rules as a condition of issuance requirements, such as covenants. All calculated profits, called rebates, must be paid to the federal government. The federal arbitration rules are designed to prevent tax-exempt bond issuers from incurring excessive or premature debt and therefore profiting from the investment of bond proceeds in income-generating investments.

Federal income tax laws limit the ability to win arbitration under tax-exempt bonds or other tax-advantaged federal bonds. Arbitration must be carefully calculated and documented to comply with potential IRS arbitration discount review. Profits must be declared IRS Form 8038-T and must be filed at least once every five years. Failure to comply with these requirements may result in financial penalties or loss of the bond’s tax-exempt status.

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