Negative Arbitrage
Contents
Demystifying Negative Arbitrage: Understanding Opportunity Costs in Debt Financing
Understanding Negative Arbitrage
Negative arbitrage represents the lost opportunity when bond issuers hold proceeds from debt offerings in escrow, earning a lower rate of return than what they must ultimately pay back to debt holders. This phenomenon typically arises when prevailing interest rates decline during the period when the funds are held in escrow, leading to an opportunity cost for the issuer.
Exploring Negative Arbitrage in Practice
Negative arbitrage manifests when the cost of borrowing exceeds the return on investment. For instance, a state government issuing municipal bonds to finance a project may face negative arbitrage if prevailing interest rates decrease after the bond issuance, causing the invested proceeds to earn a lower return than the bond's interest rate. This results in diminished funds available for the intended project, highlighting the financial impact of negative arbitrage.
Mitigating Negative Arbitrage through Refunding Bonds
Refunding bonds offer a glimpse into the mechanisms of mitigating negative arbitrage. When interest rates drop below the coupon rate on callable bonds, issuers may opt to refinance their debt at lower prevailing rates. However, call protection provisions may delay the redemption of existing bonds, prompting issuers to invest proceeds from new bond issuances in Treasury securities until the call date. If the yield on Treasury securities falls below the yield on refunding bonds, negative arbitrage ensues, necessitating a larger issue size to offset lost investment yield in the escrow fund.