What is Negative Arbitrage?
How Does Negative Arbitrage Work?
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 Does Negative Arbitrage Matter?
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.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
Though all families are different, there may be one common thread woven through each one: the ability to make sound financial decisions is not a trait all family members are blessed with. ...Read More →
I probably don't have to tell you this, but the odds are stacked against you when it comes to "beating the market." By nearly 6 to 1, in fact... ...Read More →
Many of us wish for less complexity in our lives. From relationships to finances, we crave simplicity. But life doesn't really allow for that most of the time. You're juggling your...Read More →