In theory, borrowers of tax-exempt bond proceeds can reinvest those proceeds in securities that earn above the rate they borrowed at. If the earnings on the invested securities are greater than the yield the borrower is paying on their bonds, the excess earnings are called “arbitrage.” Tax-exempt borrowers are typically required to rebate positive arbitrage back to the US Treasury.
Arbitrage Yield
The objective of the arbitrage yield is to calculate what the US Treasury feels is the borrowing rate of the tax-exempt bond issue. The arbitrage yield is the maximum earning yield proceeds can earn from a tax-exempt bond issue, excluding certain moneys based on specific Treasury rules.
The arbitrage yield is the rate at which the present value of the bond series’ cash flow (P&I) equals the amount of money the borrower receives from the sale of the securities on the delivery date.
The amount of money received from the sale of the securities is defined as:
+ lFace amount of the bond series
- lCombined original issue discount (OID)
+ Combined original issue premium (OIP)
- Bond insurance premium or surety cost (if applicable)
+ Accrued interest
= lMoney received
Any earnings generated from the bond proceeds that earn above the arbitrage yield must be rebated to the Treasury. Bond proceeds that meet certain criteria can earn above the arbitrage yield; one example of this is construction fund proceeds spent in total within six months of the delivery date.
What’s important here?
The arbitrage yield is the mechanism used by the US Treasury to limit the amount of earnings a tax-exempt borrower can make on the proceeds of a bond issuance.
Municipal taxable transactions do not have the concept of an arbitrage yield, and any bond proceeds not spent upfront on the delivery date can be invested at the highest rate available in the open market.
