Title: Understanding Negative Arbitrage — What It Is, How It Works, and Practical Steps to Manage It
Source: Investopedia — https://www.investopedia.com/terms/n/negativearbitrage.asp
Introduction
Negative arbitrage is an opportunity cost that arises when an issuer of debt receives proceeds from a new bond issue and places those proceeds in safe short‑term investments (typically cash or Treasury securities) until the funds can be used to fund a project or repay outstanding bonds. If the yield earned on those investments is lower than the interest the issuer will ultimately pay to bondholders, the issuer suffers negative arbitrage: the borrowing cost exceeds the reinvestment return.
Key ideas
– Negative arbitrage = borrowing rate > reinvestment rate on held proceeds.
– Common in advance refundings and in any situation where proceeds are held in escrow before use.
– Results in lost investment income (opportunity cost) and can increase the size and cost of a new issue.
(Concept and examples summarized from Investopedia.)
How negative arbitrage works (plain explanation)
1. Issuance and escrow: An issuer sells bonds at a fixed coupon (the borrowing cost) and temporarily places proceeds in an escrow (cash, money market, or Treasury securities) until funds are needed.
2. Yield gap: If market interest rates fall after pricing, the escrow investments may earn less than the coupon on the issued bonds. The difference is negative arbitrage (a lost yield).
3. Effect on projects/refunding: That lost yield reduces funds available for the issuer’s project or increases the net cost of refinancing an outstanding issue. In an advance refunding, if escrowed Treasury yields are below the coupon on the new (refunding) bonds, the escrow will not produce as much cash flow without using more principal — often making the refunding uneconomic or requiring a larger issue.
Simple numeric example
– Issuer sells $50 million of bonds at 6% coupon.
– Proceeds sit in a money market yielding 4.2% for 1 year.
– Negative arbitrage = (6.0% − 4.2%) × $50,000,000 = 1.8% × $50,000,000 = $900,000 lost in potential interest relative to the cost of borrowing.
Negative arbitrage in advance refundings
– When an issuer refinances callable bonds, proceeds of the refunding may be placed in an escrow of Treasuries until the call date.
– If Treasury yields are below the coupon on the refunded bonds, more principal of Treasuries is required to replicate the refunded bonds’ cash flows. That can make the refunding infeasible or require issuing a larger principal amount.
– In short: low escrow yields + high refunded coupon = greater escrow principal needed → potential negates the benefit of refunding.
Measuring negative arbitrage
– Per period (e.g., annual): Negative arbitrage = (coupon on issued/refunding bond − yield on escrowed investments) × principal invested.
– Over multiple periods: sum the period-by-period shortfall (or compute present value of the shortfalls using an appropriate discount rate).
– For refundings, compare present value of debt service on outstanding bonds vs. combined present value of debt service on refunding issue plus projected escrow earnings. If escrow earnings reduce the net present savings to negative, the refunding is uneconomic.
Practical steps for issuers and financial managers to prevent or manage negative arbitrage
1. Plan timing carefully
– Time issuance to minimize the length of time proceeds must sit idle. Avoid issuing far in advance of project needs when possible.
– For refundings, consider waiting until the bonds are callable to avoid long advance-refunding escrows.
2. Accurately forecast cash needs and market moves
– Build realistic schedules for when funds are needed.
– Model likely market rate scenarios (sensitivity analysis) to estimate possible negative arbitrage under different interest‑rate environments.
3. Minimize time in low‑yield escrow
– Use “just-in-time” delivery or draw-down structures where allowed.
– Stagger issuances to match cash flow needs if projects permit.
4. Consider current refunding instead of advance refunding
– If bonds are currently callable, a current refunding eliminates lengthy escrows and reduces the exposure to low escrow yields.
5. Structure the escrow to maximize permitted yield
– Within legal and tax constraints, choose the highest-yielding permitted investments for escrowed proceeds (e.g., Treasury notes vs. Treasury bills vs. money market instruments). Consult bond counsel—tax and municipal bond rules limit allowable investments in some cases.
6. Use hedging and synthetic alternatives
– Interest rate swaps, forward-starting swaps, or other hedges can be used to lock in rates or reduce the mismatch between borrowing and reinvestment yields. These are complex and require credit, legal and accounting review.
7. Evaluate variable-rate or floating-rate issuance
– In some cases, variable-rate debt or other structures can reduce the cost of carry while proceeds are idle, though these carry other risks.
8. Account for negative arbitrage in sizing the issue
– If negative arbitrage is unavoidable, explicitly include estimated negative arbitrage costs in the financing plan so the issue size and project budget reflect the true net funds available.
9. Use defeasance alternatives prudently
– Some issuers use alternative defeasance strategies; these should be evaluated for cost-effectiveness versus the negative arbitrage they create.
10. Engage professional advisers
– Coordinate with underwriters, financial advisers, bond counsel, and escrow agents to ensure the structure is legal, minimizes negative arbitrage, and matches issuer goals.
A practical checklist before proceeding with an advance refunding or any issuance where proceeds will be escrowed
– Determine the earliest date cash must be used.
– Model escrow yields under multiple market scenarios.
– Calculate negative arbitrage per scenario and on a present-value basis.
– Compare net present value (NPV) of refunding savings versus cost including negative arbitrage.
– Explore alternative structures (current refunding, swaps, variable-rate, draw-down).
– Confirm permitted escrow investments under tax law and bond documents.
– Get bond counsel and financial adviser signoff; document rationale and sensitivity results.
When negative arbitrage makes refunding uneconomic
– If required escrow principal to match outstanding debt service exceeds the outstanding bond principal (or the NPV savings are negative once negative arbitrage is included), most issuers will defer the advance refunding until market rates move favorably or the bonds become callable.
Conclusion
Negative arbitrage is a real and sometimes material cost for issuers who must hold new bond proceeds in low‑yield investments before use. It is particularly important in advance refundings, where escrow yields can be meaningfully lower than bond coupons and may force a larger issue or negate refinancing savings. Issuers should model outcomes, time issuance carefully, consider refunding alternatives, and work with advisors to reduce the risk and economic impact of negative arbitrage.
Reference
– Investopedia: “Negative Arbitrage” — https://www.investopedia.com/terms/n/negativearbitrage.asp
(Continued)
Implications for issuers and investors
– For issuers: negative arbitrage increases the effective cost of borrowing and can reduce the net proceeds available for the underlying project or repayment. In refunding situations it may require issuing a larger principal amount to generate the escrow cash flows needed to defease the older bonds, which can negate the economic benefits of the refinance.
– For investors: negative arbitrage is primarily an issuer-side concern, but investors should be aware of how escrowed proceeds are invested and the effects on yield comparisons across issues. Credit-rating agencies and bond counsel will evaluate the escrow structure and the effect on bondholder protections.
More examples and numerical illustrations
1) Simple issuance example (extended from earlier)
– Situation: A state issues $50,000,000 of bonds with a coupon of 6.0% to fund a project. Proceeds are received now but will not be spent for one year. The issuer invests proceeds in a money market account yielding 4.2% for one year.
– Lost opportunity (negative arbitrage) = principal × (coupon − reinvestment yield) × time
= $50,000,000 × (6.0% − 4.2%) × 1
= $50,000,000 × 1.8% = $900,000.
– Interpretation: The issuer will pay bondholders $3,000,000 in interest during the year (6% of $50m), but the invested proceeds will earn only $2,100,000 (4.2% of $50m), leaving a shortfall of $900,000 that effectively raises the net financing cost.
2) Advance-refunding example (escrow principal inflation)
– Situation: Outstanding callable bond: $10,000,000 par, coupon 6%, single maturity in 10 years (annual coupon payments of $600,000 plus $10,000,000 principal at year 10). Market conditions allow issuance of refunding bonds at 4%, but because of call protection the issuer must establish an escrow now using Treasury securities yielding 2.0% until the call date (10 years).
– Goal: Escrow must produce the same cash flows ($600,000 each year for 10 years and $10,000,000 principal at year 10).
– Present value of required cash flows discounted at the Treasury yield r = 2.0%:
PV_interest = 600,000 × [1 − (1 + r)^−n] / r
≈ 600,000 × 8.98245 = $5,389,470
PV_principal = 10,000,000 / (1.02)^10 ≈ $8,203,500
Total PV needed ≈ $13,592,970
– Conclusion: To match the old bond’s cash flows with 2% securities, the issuer must buy about $13.59m of Treasuries — greater than the $10m of outstanding bonds. That extra principal must come from a larger refunding issue (or from other sources), which may negate the savings from the lower coupon on the new bonds. This is the core of negative arbitrage in advance refunding.
Why negative arbitrage matters in practice
– Feasibility: When negative arbitrage is large, an advance refunding that looks attractive on coupon rates alone may have no net savings once escrow costs are included.
– Issue size distortions: To generate sufficient escrow cash flows with low-yield securities, the refunding issue size may have to be materially larger, complicating debt capacity and voter/board approvals for government issuers.
– Accounting and budget effects: For governmental issuers, additional issuance costs and larger debt service can affect debt ratios, budget forecasts, and disclosures to rating agencies.
– Rebate and tax implications: For tax-exempt municipal issuers, arbitrage rules (IRS Section 148) and the requirement to rebate arbitrage earnings can interact with escrow reinvestments. (Note: tax-law changes such as the Tax Cuts and Jobs Act of 2017 affected advance refunding for tax-exempt municipal bonds; issuers should consult counsel for current rules.)
Practical steps issuers should take to manage or avoid negative arbitrage
1. Model cash flows precisely before issuing
– Build a spreadsheet that models prospective bond proceeds, expected reinvestment yields in escrow, timing of project draws or call dates, and the present value of both the refunded and refunding debt service streams.
– Calculate the negative-arbitrage dollar amount and its effect on net present value and on required issue size.
2. Compare current vs advance refunding
– Current refunding (refinancing once old bonds are callable) avoids needing an escrow and therefore avoids the mismatch between refunding coupon and escrow reinvestment yields.
– Advance refunding (placing proceeds in escrow until call date) exposes the issuer to the reinvestment yield differential and hence to negative arbitrage.
3. Choose escrow investments carefully
– Use the highest-yielding permitted, creditworthy investments consistent with legal and rating-agency requirements — for many issuers that means Treasury or government obligations.
– Consider guaranteed investment contracts (GICs) or other instruments that lock in a yield, subject to legal and counsel review.
4. Shorten the gap between issuance and expenditure
– Time issuance closer to when funds are needed to reduce the period in which proceeds must be invested at lower yields.
5. Use hedging or structured products cautiously
– Interest-rate swaps, forward purchase agreements, or other derivatives can hedge reinvestment risk but add counterparty, legal, and accounting complexity. Obtain legal, tax, and financial advice.
6. Evaluate coupon structure and timing
– Lower-coupon refunding issues reduce the coupon/reinvestment spread—and could reduce negative arbitrage—but may affect marketability. Consider serial maturities, sinking funds, or other structures.
7. Engage experienced advisors
– Underwriters, municipal advisors, bond counsel, accountants, and arbitrage-rebate specialists can run sensitivity analyses and advise on legal constraints (e.g., tax-exempt bond arbitrage rules).
Practical steps for investors and analysts
1. Read the official statement and offering documents
– Check how proceeds are invested, the escrow collateral, the yield on escrow securities, and any legal opinions regarding defeasance.
2. Consider the issuer’s refinancing history and call features
– Evaluate the chance of advance refunding and the likely structure; assess whether refunds have created negative arbitrage and how that may affect issuer finances.
3. Monitor escrow performance (for refunded issues)
– If a bond has been advance-refunded, verify that the escrow investments are performing as expected, since shortfalls can affect credit or elicit further issuer action.
Mitigation techniques and trade-offs
– Using current refundings instead of advance refundings avoids escrow mismatch but requires waiting for call dates (may miss rate-window savings).
– Maximizing escrow yields by selecting higher-yield permitted investments reduces negative arbitrage but can increase credit or legal risk, or run afoul of tax rules.
– Forward refunding/forward delivery or structured swaps can lock in rates, but come with counterparty and complexity risks.
– Sometimes the only viable path is to accept a modest negative arbitrage if refinancing savings, after accounting for it, still produce overall present-value savings or other strategic benefits.
Regulatory, tax, and market considerations
– Tax-exempt bond issuers must consider arbitrage restrictions and potential arbitrage-rebate calculations under federal tax law (see IRS arbitrage rules, Section 148).
– The Tax Cuts and Jobs Act of 2017 changed aspects of advance refundings for tax-exempt municipal bonds; issuers should consult counsel and current guidance.
– Rating agencies will evaluate the escrow structure and negative-arbitrage effects on debt service and credit metrics.
Checklist for an issuer considering a refunding
– Determine whether you need an advance refunding or can do a current refunding.
– Model refunding bond cash flows and compute present-value savings both with and without escrow (include negative arbitrage).
– Obtain firm quotes for refunding coupons and for permitted escrow investments (Treasuries, GICs, etc.).
– Run sensitivity analyses for changes in Treasury yields and reinvestment rates.
– Consult bond counsel on tax and legal limitations, and an arbitrage rebate specialist if tax-exempt bonds are involved.
– Evaluate non-financial considerations (rating agency reactions, public perception, approval needs).
– Make an informed decision balancing savings, risk, and complexity.
Concluding summary
Negative arbitrage is the lost opportunity (or added implicit cost) that arises when debt proceeds are invested at yields lower than the interest rate the issuer must pay on that debt. It commonly appears in advance refundings where newly issued proceeds are held in low-yield escrow securities until older debt is callable. The practical consequence is that issuers may have to issue more principal or accept higher effective costs, sometimes negating the apparent benefits of refinancing. Careful modeling, sound escrow investment choices, consideration of current vs advance refundings, and consultation with legal and financial advisors are essential to identify, measure, and—where possible—mitigate negative arbitrage. For tax-exempt issuers, federal arbitrage rules and post-2017 legislative changes must also be factored into any refunding plan.
Source
– Investopedia: “Negative Arbitrage” — https://www.investopedia.com/terms/n/negativearbitrage.asp
(Also see IRS arbitrage rules (Section 148) and current municipal-bond tax guidance; consult bond counsel for issuer-specific advice.)
[[END]]