Arbitrage in the government bond market refers to the difference between the amount of interest gained on funds, which have been borrowed at a lesser tax-free rate and the interest on funds, which have been invested at a taxable rate rendering a greater yield.
According to the 1986 Tax Act, barring few instances or exceptions, it is mandatory that arbitrage income has to be brought together with the federal government. Government bond arbitrage is also known as municipal arbitrage or municipal bond relative value arbitrage. This is a hedge fund strategy, which follows one or the other of the following methods.
Usually, the hedge fund managers try to search for opportunities of proportional value from both short term and long term municipal bonds through a duration neutral book.
Proportional value trading may take place between various issuers or various bonds, which have been issued by the same organization, or trading on capital structure with reference to similar assets (this is applicable for revenue bonds).
The principal aim of the hedge fund managers is to appropriate the inefficiencies resulting from the high level of involvement of casual/non-economic investors, for example, the buy and hold investors (high income) who look for tax free earnings and also the crossover buying resulting from the variations in the income tax conditions of the individuals or corporations.
On the other hand, the fund managers build portfolios on the basis of leverage on tax free municipal bonds with the rating of AA- or AAA- and the duration risk in this process is hedged with the help of short selling the suitable proportion of corporate bonds, which are taxable in nature. The corporate devices commonly utilized include interest rate swaps with reference to BMA (Bond Market Association) or LIBOR (London Interbank Offered Rate). The arbitrage is represented as a category of comparatively low priced municipal bond with an extended maturity period and that is a municipal bond, which provides a significant yield of greater than 65% in comparison to the yield provided by a similar type of taxable corporate bond.
The sharp inclination of the yield curve of the municipal bond lets the participants to accumulate greater after tax earnings from the portfolio of municipal bonds in comparison to what is paid out in case of interest rate swaps, the take is always more than the expenditure on hedging. It can be positively said that tax free income from municipal bond arbitrage can go upto double figures. Through the implementation of this strategy, the duration risk and credit risk can be reduced to a considerable extent. Nevertheless, the basis risk may arise as a result of imperfect hedging and the consequence is principal volatility limited by a range. As the inefficiency is associated with the tax policy of the government and it is a structural risk, it cannot be arbitraged.