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Municipal Bond Arbitrage is the investing tactic of buying a high quality municipal bond while at the same time selling lower quality corporate bond with a lower comparable effective yield.
1. Municipal Bond
Arbitrage
Municipal relative value bond arbitrage; is the investing tactic of buying a
high quality municipal bond while at the same time selling a lower quality
corporate bond with a less than comparable tax effective yield.
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2. How to Build a Municipal Bond Arbitrage Trade:
• Step 1: Determine which municipal and corporate bond you are
going to use to structure this trade by calculating their respective tax
equivalent yields, pick the between the bonds that are below this
mark. I would just arbitrage bonds with the same trading coupon
rate, that way I now I will be profiting from the tax exemption
benefit.
• In my opinion the best type of municipal bonds to be long of are revenues
backed bonds; especially if they are related to transportation taxes like toll
roads.
• On the other hand the best kind of corporate bonds to be short of, are high
yield “junk” bonds, especially if they are issued by low growing businesses.
• Step 2: Simultaneously place an order that buy municipal bonds and
sell corporate bonds.
• Do not take debt, in order to acquire the municipals bonds. The reason why is
because of the pro rata interest disallowance rule of the American Recovery
and Reinvestment Act of 2009. This rule tells us that interests paid on debt
used to invest on tax exempt securities like municipals bonds are not tax
deductible. www.arbitrageportfolio.com
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