What Is Negative Arbitrage?
Let me explain negative arbitrage directly to you: it's the opportunity you've lost when, as a bond issuer, you take proceeds from debt offerings and park that money in escrow—usually in cash or short-term treasury investments—for some time until you can actually use it to fund a project or repay investors. This can happen with a new bond issue or after refinancing debt.
The real hit comes from the opportunity cost: you're reinvesting that money at a rate lower than what you have to pay back to your debt holders.
Key Takeaways
- Negative arbitrage is an opportunity cost from holding debt proceeds in escrow until you can fund a project.
- It happens if interest rates fall during this holding period, which might last from days to years.
- The cost is basically the difference in your net borrowing cost to creditors minus what you earn on those proceeds.
- Callable and refunded bonds are ways issuers like you can shield against negative arbitrage.
How Negative Arbitrage Works
Negative arbitrage kicks in when you, as a borrower, pay off debts at a higher interest rate than what you're earning on the money set aside for repayment. In simple terms, your borrowing cost exceeds your lending cost.
Take this example: suppose a state government issues $50 million in municipal bonds at 6% to fund a highway. But while the offering is processing, market interest rates drop. You invest the proceeds in a money market account at just 4.2% for a year, because that's all the market offers. You're losing out on 1.8% interest you could have earned or saved. That 1.8% is the negative arbitrage—pure opportunity cost. For the state, this means fewer funds for the highway, impacting citizens directly.
Negative Arbitrage and Refunding Bonds
You can see negative arbitrage in action with refunding bonds. If interest rates drop below the coupon rate on existing callable bonds, an issuer will likely pay off the bond and refinance at the lower market rate. The proceeds from the new refunding bond go toward settling interest and principal on the old refunded bond. But some bonds have call protection, preventing early redemption, so you buy Treasury securities with the new proceeds and hold them in escrow. Once the call protection ends, you sell the Treasuries and use the money to retire the old bonds.
If the yield on those Treasury securities is below the refunding bonds' yield, negative arbitrage hits from the lost investment yield in escrow. This leads to a larger issue size, often making advance refunding unfeasible. When refunding high-interest bonds with low-interest ones, you need more government securities in escrow than the outstanding bonds' amount. To match the higher interest payments of the old bonds with lower-yield Treasuries like bills, you derive the difference from more principal—the escrow cash flow must equal the outstanding bonds' cash flow.
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