To reduce the duration risk in a portfolio of high-quality, tax-exempt municipal bonds, municipal bond arbitrage entails selling short an equivalent amount of taxable corporate bonds. The most common type of these corporate equivalents is an interest rate swap based on Libor or BMA (short for Bond Market Association). Participants may earn more after-tax income from the municipal bond portfolio due to the steeper slope of the municipal yield curve. 10% is the maximum positive carry that is tax-free. Municipal bond arbitrage is a bet that two financial products will perform differently over time despite being extremely identical to one another at first. By employing this strategy, credit risk and duration risk are significantly reduced.
However, a subpar hedge increases basis risk. To protect a portfolio of tax-exempt municipal bonds, shorting identical taxable corporate bonds with the same maturity is a type of municipal bond arbitrage. High-income tax investment may be a particularly tempting alternative for some investors. Since municipal bonds are tax-exempt, investors can control the duration risk of their portfolios. To protect a portfolio of tax-exempt municipal bonds, mortgage bond arbitrage comprises shorting identically similar taxable corporate bonds with the same maturity. Other names for it include 'muni-arb,' 'muni-bond relative value arbitrage,' and 'muni-arb.'
The municipal bond arbitrage approach aims to lower credit and duration risk by using municipal bonds and interest rate swaps of equivalent quality and maturity. This strategy implicitly assumes that municipal bonds will continue to have identical terms and credit quality, as well as a strong correlation with interest rates. Municipal bonds may not offer the same interest rate as the after-tax gains from an interest rate swap arbitrager. Arbitrage opportunities are low-risk since they involve little to no negative cash flow. Investors who are subject to high-income tax rates might find this strategy especially tempting. Municipal bond arbitrage gains are tax-free up to 10%. To benefit from the lower tax rate, municipal bond investors will buy top-tier, tax-exempt municipal bonds and sell matching taxable corporate bonds. Arbitrage on municipal bonds is computed using intricate calculations and variables.
Issuers of tax-exempt municipal bonds are required to abide by strict federal requirements on arbitrage compliance. Arbitrage is prohibited by federal law to prevent tax-exempt bond issuers from taking on excessive or unnecessary debt. Calculated profits that must be remitted to the federal government are known as rebates. Although it requires exact calculation and documentation, it is feasible to arbitrage between tax-exempt bonds and other types of bonds. An IRS Form 8038-T must be filed at least every five years to record profits. You run the risk of paying fines or losing your tax-exempt status if you don't follow these regulations. Arbitrage is the process of generating income by reinvesting the profits of loans with low-interest rates in goods or securities with greater returns.
Alternative definition: For municipal bonds, the difference between interest expenses incurred by the bond debt issuer and gains from investments made with the proceeds. Bond covenants or other issuance restrictions for tax-exempt municipal bond issuers may include language requiring conformity to federal arbitrage laws. The rules forbid tax-exempt bond issuers from incurring excessive or early debt and profiting from the investment of bond proceeds in assets that generate income. Arbitrage computing is an exceedingly complex process. Complex computations are necessary to determine many factors, such as the actual yield on a bond issue.
Arbitrage compliance is subject to stringent reporting regulations set by the IRS. Failure to file or comply with the rules may result in financial fines or a loss of the bonds' tax-exempt status. Some arbitrage computations must be performed more frequently than permitted by IRS law due to bond covenant obligations. Governmental CPAs from the CRI may be able to help an organization comply with federal arbitrage rules. Arbitrage calculations are complex, and detailed records must be kept to comply with IRS regulations.
It's critical to comprehend the significance of timing, financial planning, and legal requirements. Infrastructure projects like roads and schools are financed with the help of financial instruments known as municipal bonds. These bonds normally have a long maturity and little liquidity, but their interest is not taxed at the federal level. To hedge the duration of municipal bonds, investors can short comparable taxable corporate bonds with the same maturity using interest rate swaps. Because municipal bonds are exempt from income tax, the after-tax revenue from the bonds should be more than the interest paid on the swaps.
States, towns, and other local governmental bodies sell municipal bonds to raise money for infrastructure projects including roads, schools, hospitals, and bridges. These bonds' interest is not subject to federal or state taxation in the state where the bond was issued. A 4% municipal bond will have a similar after-tax yield to a 6% taxable corporate bond because interest on municipal bonds is tax-free whereas interest on corporate bonds is subject to marginal tax rates of up to 35%. Investors should be encouraged to sell muni bonds if taxable bond yields rise above muni bond rates, which should lower muni prices. Instead, investors should be incentivized to sell taxable bonds as their prices rise and their yields decrease. This is one of the things that has recently caused the price of bonds to drop.
As it has been doing, the Federal Reserve will continue to buy bonds until the economy is in better health. The Fed is buying bonds to lower interest rates. Businesses and individuals should pay less to refinance their existing debt as a result. Muni bond arbitrage was first intended to assist investors in controlling the risk associated with their municipal bond portfolios. Institutional investors and high-net-worth individuals frequently adopted the tactic (HNWIs). The popularity of the strategy peaked when many seasoned fund managers began using muni bond arbitrage to produce alpha for their clients and investing strategies.
However, due to concerns about the credit risk associated with holding tax-exempt securities due to their perceived lack of liquidity in comparison to taxable corporate bonds, many investors gave up on muni bond arbitrage strategies after the sharp decline in interest rates that followed the 9/11 attacks. When interest rates started to climb again in the two years that followed, the market for municipal paper grew, opening up opportunities for those looking to profit from it. Giving it up was a terrible idea. The muni bond arbitrage tactic became well-liked. The book 'The Ultimate Guide to Municipal Bond Arbitrage' was widely read by investors looking for alpha-building tactics during a protracted period of record-low interest rates. He discussed the advantages of muni bond arbitrage as well as its methods.
Due to this popularization, more investors started to think about muni bond arbitrage as a way to produce alpha. Municipal bonds that were exempt from taxes as a result drew more interest, which reduced the cost of those bonds. Investors were able to purchase bonds for less than their face value as a result of the price decline. Buying long-term tax-exempt municipal bonds with a lower credit rating and selling short-term taxable corporate bonds with a higher credit rating is known as 'municipal bond arbitrage.' This would be a portfolio management technique.
To achieve this, either municipal bonds should be purchased directly, or an exchange-traded fund (ETF) or mutual fund might be set up to monitor the effectiveness of this plan. The basic tenet of muni arbitrage is that investors should be encouraged to acquire taxable corporate bonds if their prices are rising and yields are decreasing, and to sell a particular municipal bond if its price is higher than its underlying yield. The convergence process should continue until taxable yields match muni yields.
Municipal bonds are a well-liked investment option for people wishing to diversify their portfolio and generate larger returns than they would with other forms of bonds due to their tax-free status. It is possible to buy municipal bond funds directly from issuers or through a middleman, like a bank or a broker. General obligation (GO) bonds and revenue bonds are the two fundamental types of municipal bonds. When buying general obligation bonds, investors incur the risk of losing their entire investment because they are supported by the issuer's complete faith and credit.
Ashly Chole - Senior Finance & Technology Editor