Profit from differences in markets. The classic example of Arbitrage with respect to Tax-Exempt Bonds is the issuance of Bonds at a lower (tax-exempt) Rate and investment of the proceeds in obligations paying higher (taxable) Rates. The difference between the two rates is Arbitrage. Congress has enacted specific rules (expanded upon in the Treasury Regulations) describing the circumstances under which the Issuer or the Borrower benefitting from borrowing at lower Interest Rates does not have to pay, or Rebate, the Arbitrage earned on the investment to the Department of Treasury.

All Tax-Advantaged Bonds are subject in one way or another to the Arbitrage requirements, which are contained in Section 148 of the Code and the Treasury Regulations that go along with it. These requirements are intended to prevent Issuers from exploiting the fact that, in general, tax-exempt Interest Rates are lower than taxable Interest Rates. Specifically, a given Issuer with a given credit situation will generally be able to borrow money at a lower Interest Rate if it can issue Tax-Exempt Bonds than when, or if, it is forced to borrow using Taxable Bonds. In contrast, when an Issuer invests the Bond proceeds that it receives from selling the Tax-Exempt Bonds, those investments typically will bear taxable Interest Rates (because the “issuer” of these investments is the bank that sells them to the Issuer rather than a state or local government). These taxable Interest Rates may in many cases be higher than the Interest Rates that the Issuer is paying to the bondholders on the Tax-Exempt Bonds that generated the proceeds that the Issuer is investing. The difference between the lower tax-exempt Interest Rate that the Issuer pays to the holders of the Tax-Exempt Bonds and the higher taxable Interest Rate that the Issuer receives on the invested Bond proceeds – a difference that could go straight into the Issuer’s pocket as pure profit is called Arbitrage.

The federal government views Arbitrage as effectively shifting the cost of the Bond-financed project onto the federal government, so Congress has enacted a number of complex limits on when and how much Arbitrage can be earned and retained by the Issuer. There are two basic questions that arise when determining compliance with the Arbitrage requirements set forth in Section 148 of the Code. 

• First, can the proceeds of the Bonds be invested at a Yield above the Bond Yield prior to expenditure?  The answer to this question is governed by the “Yield Restriction Rules.” 
• Second, even if the proceeds can be invested above the Bond Yield, can the earnings be retained or do they have to be paid back to the U.S. Treasury (through a somewhat inaptly named process call “Rebate”)?  Bonds that violate these Arbitrage rules are considered taxable Arbitrage Bonds.

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See Also

Arbitrage Bonds

Tax-exempt bonds violating yield restrictions imposed by Section 148 of the Internal Revenue Code (IRC) and Treasury Regulations promulgated thereunder.

Rebate

A requirement imposed under the Code to pay to the Internal Revenue Service an amount equal to the arbitrage earned on tax-exempt bonds.

Yield

As computed under the Code provisions applicable to bonds, the internal rate of return that causes the present value of the payments of principal and interest (and, in certain cases, certain other payments) on an issue of bonds to equal the issue price of the bonds.