Negative Arbitrage

What is negative arbitrage?

Negative arbitrage is the lost opportunity when bond issuers take on the proceeds of debt offerings and then hold that money in escrow for a period of time (usually in cash or short-term cash investments) until that the money can be used to finance a project or to repay investors. Negative arbitrage can occur during a new bond issue or following a refinancing of debt.

Opportunity cost occurs when money is reinvested and the debt issuer earns a lower rate or return than what actually has to be repaid to debt holders.

Key points to remember

  • Negative arbitrage is a lost opportunity cost of holding debt proceeds in escrow until a project can actually be funded.
  • Negative arbitrage occurs if prevailing interest rates fall during this period, which can last from several days to several years.
  • The negative arbitrage cost is essentially the difference between the borrower’s net cost to creditors minus what they can earn by using that product to borrow again.
  • Callable and redeemed bonds show how issuers can protect themselves against negative arbitrage.

How Negative Arbitrage Works

Negative arbitrage occurs when a borrower pays off their debts at a higher interest rate than the rate the borrower earns on the money set aside to pay off the debt. Basically, the cost of borrowing is greater than the cost of lending.

For example, to fund the construction of a highway, a state government issues $50 million in 6% municipal bonds. But while the offer is still going, prevailing market interest rates are falling. The proceeds from the bond issue are then invested in a money market account paying only 4.2% for a period of one year, as the prevailing market will not pay a higher rate. In this case, the issuer loses the equivalent of 1.8% interest that it could have earned or retained. The 1.8% results from a negative arbitrage which is in fact an opportunity cost. The loss suffered by the state translates into less funds available for the highway project for its citizens.

Negative Arbitrage and Reimbursement Obligations

The concept of negative arbitrage can be illustrated using the example of bond redemption. If interest rates fall below the coupon rate on existing callable bonds, an issuer is likely to redeem the bond and refinance its debt at the lower prevailing market interest rate. Proceeds from the new issue (the redemption bond) will be used to settle the interest and principal payment obligations of the current issue (the redeemed bond). However, due to call protection placed on some bonds which prevents an issuer from redeeming the bonds for a period of time, the proceeds from the new issue are used to purchase Treasury securities held in escrow. On the call date after the expiration of the call protection, the treasury bills are sold and the proceeds of the sale are used to retire the old bonds.

When the yield on Treasury securities is lower than the yield on redemption bonds, negative arbitrage occurs resulting from the loss of return on investments in the escrow fund. When there is negative arbitrage, the result is a significantly larger issue size and the feasibility of early redemption is often denied. When high interest rate bonds are prepaid with low interest rate bonds, the amount of government securities required for the escrow account will be greater than the amount of outstanding bonds redeemed. To match the debt service of the higher interest payments of outstanding bonds with the lower interest of treasury bills, such as treasury bills, the difference must be derived from a larger portion of the principal since the cash flow from the escrow must equal the cash flow on the outstanding bonds to be repaid.

About Anju Sharma

Anju Sharma is a distinguished content writer at TipsClear.com, known for her expertise in crafting engaging, informative, and SEO-optimized articles. With a strong command over diverse topics, Anju has established herself as one of the best-known content creators in the digital space. Her work seamlessly blends in-depth research with a reader-friendly approach, making complex subjects easily accessible and enjoyable for her audience. Anju’s passion for writing and her commitment to delivering high-quality content consistently set her apart in the competitive world of online content creation.

Check Also

Fed Squeezes Inflation and Economy Harder With a Tenth—Possibly Final—Rate Hike

The Federal Reserve once again increased the pressure pushing down on inflation—and the economy—for what …