What is Municipal Bond Arbitrage?
Municipal bond arbitrage refers to the methodology that an investor deploys where they leverage the tax-exempt status of municipal bonds to hedge their portfolio’s period risk.
Key Takeaways
- Municipal bond arbitrage refers to the methodology that an investor deploys where they leverage the tax-exempt status of municipal bonds to hedge their portfolio’s period risk.
- Municipal bond arbitrage involves hedging a portfolio of tax-exempt municipal bonds by way of similtaneously shorting an identical taxable corporate bonds of the identical maturity.
- Municipal bond arbitrage strategies will also be an especially sexy chance for some buyers in high-income tax brackets.
Understanding Municipal Bond Arbitrage
Municipal bond arbitrage involves hedging a portfolio of tax-exempt municipal bonds by way of similtaneously shorting an identical taxable corporate bonds of the identical maturity. Municipal bond arbitrage could also be in most cases referred to as municipal bond relative price arbitrage, municipal arbitrage or just “muni-arb”.
Period risk is the risk that an investor, in particular a bondholder, faces from changes in interest rates that may negatively impact {the marketplace} price of their fixed-income investments. The municipal bond arbitrage methodology goals to minimize credit score rating and period risk by way of using municipal bonds and interest rate swaps of similar top of the range and maturity. The implicit assumption in this means is the municipal bonds, and interest rate swaps will continue to have an in depth correlation.
Since hobby expenses from municipal bonds are exempt from federal income tax, an arbitrageur can download after-tax income from the municipal bond portfolio which is higher than the hobby paid on the interest rate exchange. This methodology will also be an especially sexy chance for some buyers in high-income tax brackets. Arbitrage possible choices are endlessly considered low-risk on account of they most often comprise very little or no damaging cash go with the flow.
For instance, municipal bondholders will endlessly achieve a portfolio of tax-exempt, high quality municipal bonds. At the an identical time, they will advertise a lot of an identical taxable corporate bonds to have the benefit of the tax price. Certain, tax-free returns from municipal bond arbitrage can achieve into the double digits.
Calculating municipal bond arbitrage requires numerous complicated components and computations. Computations include understanding the actual yield on a municipal bond issue and calculating the true allowable earnings using this actual yield. The investor would then use long run price calculations on the difference between the investment earnings receipt date and the computation date.
Municipal Bond Arbitrage Compliance
Tax-exempt municipal bond issuers are topic to strict federal arbitrage compliance rules as a scenario of issuance must haves, related to bond covenants. Any computed revenue, which may well be referred to as rebates, should be paid to the federal government. Federal arbitrage rules are designed to stop issuers of tax-exempt bond debt from obtaining excessive or premature debt and due to this fact making the most of the investment of bond proceeds in income-generating investments.
Federal income tax rules prohibit the power to earn arbitrage in connection with tax-exempt bonds or other federally tax-advantaged bonds. Arbitrage should be reasonably calculated and documented to adapt to a imaginable IRS arbitrage rebate exam. Profits should be reported on IRS Form 8038-T and should be filed at least once every 5 years. Failure to adapt to these must haves may result in financial penalties or the loss of the bonds’ tax-exempt status.
