Municipal bond arbitrage is a leveraged portfolio of tax-exempt municipal bonds hedged against a short strategy of equivalent taxable corporate bonds. The corporate equivalent taxable corporate bonds are typically interest rate swaps related to Libor. Municipal bond arbitrage is a value strategy that attempts to profit from the inefficiency that is related to federal tax exemption of municipal bonds. An arbitrage opportunity arises when the prices of the same asset in two markets differ by more than the trading cost of buying in the lower-priced market and simultaneously selling in the higher-priced market.
The arbitrage presents itself through the purchase of relatively inexpensive longer-term municipal bonds, coupled with interest rate swaps that are treated as insurance and are cheaper than the yield on long term municipal bonds. Over a long period of time, two similar instruments – the municipal bonds and interest rate swaps – will correlate with each other. However, when they do not correlate significant losses can occur for investors. Brokers must disclose these risks and make sure investors understand those risks before recommending a municipal arbitrage strategy.
The attorneys at Gana Weinstein LLP handled several cases involving the sale of municipal arbitrage funds. If you were sold a municipal arbitrage fund and believe your financial advisor did not adequately explain the risks, contact us.