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An arbitrage bond is a certain type of bond often issued from a municipality or local government in order for that municipality or local government to take advantage of a change in the market or a previously unknown market condition that can be beneficial to the bond issuer. Changes in the market that may precede an arbitrage bond issue may include lower interest rates or an opportunity to extinguish a future bond debt. Although municipalities issue these bonds, governments and corporations may also issue an arbitrage bond.
Arbitrage by definition refers to a simultaneous exchange, such as buying and selling something at the same time or at nearly the same time with the purpose of taking advantage of a disparity in a market or the product’s price. A bond is an agreement between a borrower and a lender. This agreement is often referred to as an indenture. A bond is generally referred to as a security instrument such as those that municipalities use to raise money from public sources. An arbitrage bond can therefore be a debt security that is used to extinguish a bond paying higher interest rate with one that is going to pay a lower interest rate, therefore saving the issuer money.
A convertible bond arbitrage involves convertible bonds. These exist in ways which are very similar to a regular bond, but with a major defining difference in that they can be converted to company shares later. At the time a convertible bond is issued, it is done so with the understanding it can be redeemed for equity in the issuing company. Convertible bond arbitrage takes place when a convertible bond is purchased and, at the same time, the purchaser short sells equity in the issuing company. Bond experts consider this type of bond to be a rather sophisticated investment strategy.
Arbitrage in the government bond market is another type of bond arbitrage. Also known as municipal bond arbitrage, this type is characterized by the amount of interest earned on borrowed money and the interest earned on investment funds. To wit, when the interest on funds invested amounts to greater earnings than the amount of interest earned on money that has been borrowed, this is considered municipal bond arbitrage.
Another example of a municipal arbitrage bond would be when a municipality borrows money from the public by way of a bond offering, but later discovers it can also borrow money from another source at a lower interest rate. When money borrowed at a lower rate is used to pay off the original bond, the new bond is referred to as an arbitrage bond. It is the new arbitrage bond that has helped the municipality gain a profit by way of saving money.