What is an Arbitrage Bond?

An Arbitrage bond is a bond issued by a municipality to refinance an existing higher-rate bond with a lower-rate bond prior to the call date of the former. Arbitrage bonds are issued by municipalities when they want to take advantage of the difference in the price of lower-rate security and higher rate security. Proceeds that emanate from the sale of the lower-rate bonds are put into the treasuries the higher-rate bonds reach their call date.

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How Does an Arbitrage Bond Work?

An Arbitrage difference exists between bonds with lower interest rates and those with higher interest rates. When municipalities use the arbitrage bond strategy, it helps them hedge a decline in the interest rates on existing bonds. Arbitrage bonds also reduce the cost of borrowing for municipalities. Municipal bonds have the embedded call option, an attribute that allows municipalities to redeem bonds before their maturity or call date. When a municipality issues bonds with a lower rate, the goal is to use the proceeds to refinance the existing higher-rate bonds at a lower rate. Usually, when municipalities use the arbitrage bonds strategy, it entails purchasing U.S. Treasury bills which bond with lower interest rates that can be used to refinance the existing higher-rate bonds prior to the call date.