When you hear the term “arbitrage,” your mind may wander to William Raymond “Billy Ray” Valentine (Eddie Murphy) and Louis Winthorpe III (Dan Aykroyd) feverishly trading orange juice futures in the 1980’s movie “Trading Places.” Arbitrage seems to be a concept reserved for the most elite investment traders and financiers in the world–like Randolph and Mortimer Duke in the movie. However, arbitrage exists in many different environments, including the world of tax-exempt municipal bond arbitrage which happens to be a place where Randolph and Mortimer probably wouldn’t trade.
Municipal Bond Arbitrage
Arbitrage is the term used to define the profits gained by investing proceeds derived from low interest rate debt into higher yielding investments or securities. Or in the case of municipal bonds, arbitrage is the difference between the interest expense paid by the bond debt issuer and the earnings from the invested proceeds.
Tax-exempt municipal bond issuers are subject to Federal arbitrage compliance rules as a condition of bond covenants or other issuance requirements. Federal arbitrage rules are designed to prevent issuers of tax-exempt bond debt from obtaining excessive or premature debt and subsequently benefitting from the investment of bond proceeds in income generating investments. For example, an issuer borrows money at 3%, invests the proceeds and earns investment income of 8%, resulting in a profit of 5%. Randolph and Mortimer would like that return on investment coupled with relatively low risk.
The example above is a very simplistic calculation in which arbitrage might occur. There is actually a substantial amount of complexity involved in the true calculation of arbitrage. Many factors requiring detailed computation are required, such as calculating the true yield on a bond issue, computing the allowable earnings using this true yield, and then using future value calculations on the difference from the investment earnings receipt date and the computation date. These calculations must also be presented and documented in a manner that complies with a potential IRS arbitrage rebate exam.
IRS reporting requirements for arbitrage compliance are strict. IRS Form 8038-T is used to report arbitrage profits and must be filed at least once every five years. Any computed profits called “rebates” are paid to the Federal government. As with any Federal or IRS reporting requirements, failure to file or comply with the requirements may result in financial penalties or the loss of the bonds’ tax-exempt status. Also be aware that some bond covenants require an arbitrage calculation more frequently than the IRS regulations. Reading the bond indenture carefully will reveal these types of covenants.
In the final analysis, arbitrage shouldn’t be a word exclusive to Wall Street investment gurus. It’s a concept that any municipal debt issuer should understand. The computations related to arbitrage are complex and documentation is critical for IRS compliance. CRI’s governmental CPAs can help your entity comply with the Federal arbitrage rules so that your entity doesn’t end up under the bridge with Randolph and Mortimer instead of partying with Louis and Billy Ray.