What Is Negative Arbitrage?
Negative arbitrage is the opportunity lost when bond issuers hold proceeds from debt offerings in escrow, mainly in cash or short-term treasury investments. These funds remain unused until they can be utilized to fund a project or repay investors. Negative arbitrage conditions may arise with a new bond issue or following debt refinancing.
The opportunity cost occurs when the proceeds earn a rate of return lower than the rate issuers have to pay back to debt holders.
Key Takeaways
- Negative arbitrage constitutes an opportunity cost incurred from holding debt proceeds in escrow until their use.
- It occurs if prevailing interest rates fall during the escrow period, which can last days to years.
- The costs stem from the difference between the issuer’s net interest expense to creditors and the earnings from the escrowed funds.
- Callable and refunded bonds show how issuers can mitigate against negative arbitrage.
How Negative Arbitrage Works
Negative arbitrage arises when a borrower repays its debts at higher interest rates compared to what it earns on the money set aside for debt repayment. Essentially, the borrowing cost exceeds the lending cost.
For example, to fund the construction of a highway, a state government issues $50 million in municipal bonds paying 6%. If prevailing interest rates drop while the funds are held in a money market account paying only 4.2% for a year, the issuer loses 1.8% interest potential. This 1.8% loss is an example of negative arbitrage and represents an opportunity cost. This financial loss impacts the funds available for the highway project.
Negative Arbitrage and Refunding Bonds
Negative arbitrage can be illustrated with refunding bonds. If interest rates drop below the coupon rate on existing callable bonds, issuers might refinance their debt at the lower market rate. Proceeds from the new issue, or refunding bond, will meet the interest and principal obligations of the old, refunded bond.
Due to call protection on some bonds, issuers can’t redeem these bonds immediately. They invest the new issue’s proceeds in Treasury securities held in escrow. After call protection ends, the Treasuries are sold and proceeds are used to settle the old bonds.
Negative arbitrage occurs when the yield on Treasury securities is below the yield on refunding bonds, incurring lost investment yields. Negative arbitrage results in larger issue sizes and sometimes nullifies the benefits of advance refunding. High-interest bonds being refunded by low-interest bonds require more principal to match cash flows and service debt, resulting in further complications.
Related Terms: opportunity cost, callable bonds, refunding bonds, Treasury securities, municipal bonds, cost of debt.
