In our last post about tax free investing we discussed the unique opportunity that Puerto Rican municipals bonds have to offer since they are triple tax exempt nationwide. Well now let me expand on this idea by presenting to you the investment strategy of municipal bonds arbitrage.
What is Municipal Bonds Arbitrage?
Municipal arbitrage, also known as 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 effective yield on the secondary market. Hedge funds usually execute this strategy on the derivatives market by utilizing financial instruments such as interest rate swaps (the agreement to exchange interest rate cash flows, payments).
How to Build a Municipal Bond Arbitrage Trade
Since most retail investors do not have easy access to complex financial instruments such as interest rate swaps, we have to take a more direct approach.
This is how you can structure Muni Arb position:
- Step 1: Determine which municipal and corporate bonds 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 (the effective yield). I would just arbitrage bonds with the same trading coupon rate, that way I know 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 to buy municipal bonds and short the corporate ones.
- 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.
“An even more special consideration if you are a corporate institution like an investment company or a bank.”
Once you comply with this regulation the performance of the municipal arbitrage trade will follow this equation:
Municipal Bond Arbitrage Formula:
Total Return = Municipal Bonds Coupons (Interest on Long Bond)
– Corporate Bonds Coupons (Distributions Pay-Out on Bond Short)
– Cost of Leverage (Margin Cost on Bond Short)
+ Capital Gain/Loss from Municipal Bond
+ Capital Gain/Loss from Corporate Bond
- Another option is to buy the municipal bond with real equity (cash), but short the corporate bond with margin (debt).
Two investment rules of the Arbitrageur Investing System: to follow for this arbitrage trade are…
- Never buy a bond that is trading above par (face value).
- Never short a bond that is trading below par (face value).
“As long as you understand the market trend of these bonds (bullish or bearish).”
Case Study Time
After understanding the steps required to build a municipal arbitrage trade we can conclude that it will be a lot easier to have a tool that can make all these calculations for us. In today’s case study I am going to share with you an excel spreadsheet that will output the required data…
- The coupon yield of the municipal bond
- The tax equivalent yield of the corporate bond
- The trading management cost (margin)
- The expected return of the trade
- Hedge Ratio = 100% (the long value equal the short value)
The Bottom Line
Municipal Bonds Arbitrage (Muni Arb) is another investing strategy to be aware of. Don’t forget the regulatory complications and like always the placement of the order; because we must always achieve a simultaneous execution.
Which one do you prefer to invest on? Plain old direct investing on municipal bonds, or to arbitrage them?