Negative Arbitrage

Negative arbitrage is the opportunity lost when municipal bond issuers assume proceeds from debt offerings and then invest that money for a period of time (ideally in a safe investment vehicle) until the money is used to fund a project, or to repay investors. The lost opportunity occurs when the money is reinvested and the debt issuer earns a rate or return that is lower than what must actually be paid back to the debt holders.

Negative arbitrage occurs when a borrower pays its debt at a higher interest rate than the rate the borrower earns on the money set aside to repay the debt. Basically, the borrowing cost is more than the lending cost. For example, to fund the construction of a highway, a state government issues $50 million in municipal bonds paying 6%. But while the offering is in process still, prevailing interest rates in the market drop. The proceeds from the bond issuance are invested in a money market account paying only 4.2% for a period of one year, because 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 negative arbitrage which is, in fact, an opportunity cost. The loss incurred by the city translates into less available funds for the highway project.

The concept of negative arbitrage can be explained with refunding bonds. If interest rates decrease below the coupon rate on existing callable bonds, an issuer is likely to pay off the bond and refinance its debt at the lower interest rate prevalent in the market. The proceeds from the new issue (the refunding bond) will be used to settle the interest and principal payment obligations of the outstanding issue (the refunded bond). However, due to the call protection placed on some bonds which prevents an issuer from redeeming the bonds for a period of time, proceeds from the new issue are used to purchase Treasury securities held in escrow. On the call date after the call protection elapses, the Treasuries are sold and the proceeds from the sale are used to retire the older bonds.

When the yield on the Treasury securities is below the yield on the refunding bonds, negative arbitrage occurs resulting from lost investment yield in the escrow fund. When there is negative arbitrage, the result is a significantly greater issue size and the feasibility of the advance refunding is often negated. When high interest rate bonds are advance refunded with low interest rate bonds, the amount of government securities required for the escrow account will be greater than the amount of outstanding bonds being refunded. To match the debt service of the higher interest payments of the  outstanding bonds with the lower interest of Treasuries, such as Treasury bills, the difference must be derived through more principal since the cash flow from the escrow must equal the cash flow on outstanding bonds to be refunded.