What it is:
How it works (Example):
For example, let's assume that XYZ City wants to build several new bridges. It issues $100,000,000 of 5% municipal bonds in order to pay for the construction costs. The bond sale is successful, but while the offering is in process, interest rates fall across the board.
Once the offering is done and XYZ City obtains the $100,000,000, the city puts the bond proceeds in several bank accounts that it will use to pay for the construction as the costs are incurred. However, due to the changes in interest rates, XYZ City ends up earning only 2% in the bank accounts while paying bondholders 5%. Thus, XYZ City loses 3% due to negative arbitrage.
Bond issuers try to avoid negative arbitrage by creating draw-down funds, which allow borrowers to pay interest only on the portion of the proceeds that has been used. Draw-down funds are sometimes part of private placements. Investing proceeds more aggressively is another (albeit riskier) option.
Why it Matters:
Negative arbitrage is an opportunity cost. In our example, changes in interest rates forced XYZ City to invest at a lower rate than it pays out. In turn, less money is available for the actual construction costs. This is one example of how Federal Reserve efforts to stimulate the economy by lowering short term interest rates can actually increase opportunity costs and inadvertently stymie infrastructure investment.