What is Arbitrage?

"Arbitrage" is the profit made from investing inherently lower yielding tax-advantaged debt proceeds in higher yielding taxable investments. Arbitrage rebate payments are required if the investment yield earned on the gross proceeds of the debt issue are invested above the bond yield. The funds that are subject to arbitrage rebate are:

  • Project Funds
  • Reserve Funds
  • Debt Service Funds
  • Refunding Escrow Funds
  • Cost of Issuance Funds
  • Transferred Proceeds
  • Disposition Proceeds

Arbitrage rebate is accumulated from the date the bonds are issued until the bonds mature. Since interest rates are in constant flux, during certain time periods the rate of return may exceed the bond yield (positive arbitrage rebate) or yield lower than the bond yield (negative arbitrage rebate). The calculation of arbitrage rebate nets the positive arbitrage rebate and negative arbitrage rebate over the life of the bond issue. IRS required filing dates for Rebate Payments are every five years and at the date the debt goes final.

Below is a typical example of arbitrage: the blue line represents the debt issue’s yield and the fluctuating orange line is the actual investment yield for a Government Investment Pool. Note the areas of positive arbitrage and negative arbitrage. The basic laws of arbitrage minimize benefits of investing tax-exempt debt proceeds in the taxable marketplace and remove incentive to issue debt earlier than needed, to leave debt outstanding longer than necessary and to issue more debt than necessary for governmental purpose.

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