What is municipal bond arbitrage?

A strategy in which an investor takes advantage of the tax exemption on municipal bonds to hedge the duration risk associated with these bonds by short selling interest rate swaps.

Where have you heard about municipal bond arbitrage?

The tax exemption on municipal bonds makes them attractive to investors in high-income tax brackets. Arbitrage is a way of reducing one of the risks associated with these bonds – changing interest rates.

What you need to know about municipal bond arbitrage.

Municipal bonds are debt securities used to finance capital projects such as constructing highways, hospitals or schools. The interest on these bonds is exempt from federal income tax. The downsides are that they’re often illiquid and have a long maturity, making them susceptible to interest rate change.

Investors may hedge this duration risk by short selling equivalent taxable corporate bonds with the same maturity. These are usually interest rate swaps. Because municipal bonds are exempt from income tax, the after-tax income from the bonds should be more than the interest paid on the interest rate swaps.

When carrying out municipal bond arbitrage, an investor assumes that municipal bonds and interest rate swaps will continue to correlate with each other.

Find out more about municipal bond arbitrage.

Read our guide to interest rate swaps to discover why they’re commonly used in municipal bond arbitrage.