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Arbitrage Bonds (Municipal Bond Arbitrage)

Moneyzine Editor
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Moneyzine Editor
1 mins
November 6th, 2024
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Arbitrage Bonds (Municipal Bond Arbitrage)

Definition

The term bond arbitrage refers to the practice of refinancing a higher-rate bond prior to its call date with a lower rate security. Issuing arbitrage bonds is an effective strategy when interest rates are declining.

Explanation

Also known as municipal bond arbitrage, an arbitrage bond is one that is issued to take advantage of declining interest rates and bond yields. This is accomplished by refinancing a higher rate security ahead of its call date with a lower interest rate bond. In doing so, the municipality reduces their effective cost to borrow. Once issued, the proceeds from the lower interest rate bonds are typically transferred to a risk-free investment such as Treasury securities until the call date of the original bonds.

The ability to lower the effective cost to borrow is sensitive to interest rates. For example, the coupon rate of the newly issued bonds must be significantly lower than the original security. If not, the cost to issue the new bonds may be greater than the savings achieved by the refinancing process.

Related Terms

  • The term statistical arbitrage refers to the practice of using sophisticated mathematical models to identify potential profit opportunities from a pricing inefficiency that exists between two or more securities. Statistical arbitrage requires the use of high speed computers, computational models, as well as complex trading systems.
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  • Against the Box (Selling Short Against the Box)
    The term against the box refers to the practice of selling short securities that are held in safekeeping or owned. Selling short against the box provided investors with a mechanism to defer paying federal income tax on a capital gain.
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  • The term stale price arbitrage refers to the ability to profit from the price of securities that do not reflect all of the available market information. Stale price arbitrage is possible because securities are traded on exchanges located in different time zones.
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  • International Arbitrage
    The term international arbitrage refers to the practice of simultaneously buying and selling a foreign security on two different exchanges. International arbitrage is profitable when pricing inefficiencies occur due to factors such as timing and exchange rates.
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  • Discount Arbitrage
    The term discount arbitrage refers to the practice of simultaneously buying a discount option and taking the opposite position in the underlying security. Discount arbitrage is considered a riskless strategy, since the trader is engaging in a covered option.
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  • The term Regulation SHO refers to legislation that updated and strengthened the laws concerning short sales of securities. Regulation SHO established trading standards intended to lower the opportunity for traders to engage in unethical naked short selling practices.
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  • Failure to Deliver (Fails to Deliver)
    The term failure to deliver refers to a transaction involving the exchange of assets, wherein one party does not deliver their asset. Failure to deliver typically refers to the inability of one party to provide securities to their broker.
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  • Aged Fail
    The term aged fail refers to a transaction between two brokers that remains open 30 days or more after the settlement date. Aged fails can occur when a party that agreed to sell securities does not deliver them to their broker.
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