DEFINITION of negative arbitrage
Negative arbitrage is the opportunity lost when municipal bond issuers assume the proceeds of the debt offers and then invest that money for a period of time (ideally in a safe investment vehicle) until the money is used to finance a project or to reimburse investors. The lost opportunity occurs when the money is reinvested and the debt issuer earns a lower rate or return than what must actually be paid back to the debt holders.
BREAKDOWN Negative Arbitration
Negative arbitrage occurs when a borrower pays his debt at a higher interest rate than the rate he earns on money set aside to pay off the debt. Basically, the cost of borrowing is greater than the cost of loan. For example, to finance the construction of a highway, a state government issues $ 50 million in municipal bonds paying 6%. But while the offer is still going on, prevailing market interest rates are falling. The proceeds of the bond issue are invested in a money market account paying only 4.2% for a period of one year, since 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 kept. The 1.8% results from a negative arbitrage which is in fact an opportunity cost. The loss suffered by the city results in a decrease in the funds available for the highway project.
The concept of negative arbitrage can be explained by the redemption of bonds. If interest rates fall below the coupon rate on existing redeemable bonds, an issuer is likely to repay the bond and refinance its debt at the lower prevailing market interest rate. The proceeds of the new issue (the repayment obligation) will be used to settle the interest and payment obligations in principal of the current issue (the repaid obligation). However, because of the call protection placed on certain 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 on deposit. On the date of the appeal after the expiration of the protection, the treasury bills are sold and the proceeds of the sale are used to withdraw the older bonds.
When the yield on Treasury securities is lower than the yield on redeemable bonds, negative arbitrage occurs due to the loss of return on investments in the escrow fund. When there is negative arbitrage, the result is a much larger issue size and the feasibility of early redemption is often canceled. When high interest rate bonds are redeemed in advance with low interest rate bonds, the amount of government securities required for the escrow account will be greater than the amount of outstanding bonds that are redeemed. To match the debt service of higher interest payments on outstanding bonds with the lower interest on treasury bills, such as treasury bills, the difference must come from more capital since the cash flow from of the escrow must be equal to the cash flow of the outstanding bonds to be repaid.