Arbitrage presents challenges, and since 2022, opportunities for issuers to lower their borrowing costs if they can stay within the parameters enforced by the Internal Revenue Service.
"Given this current interest rate environment we're in, definitely be thinking about positive rebate payments," said Sandee Stallings, president and CEO of BLX.
"It's a very realistic scenario for a lot of clients currently making multi-million-dollar arbitrage payments. You're not alone if you do have to make a rebate payment."
The comments came during a discussion on Tuesday at the Government Finance Officer Association's Mini Muni Conference.
Arbitrage becomes interesting to the IRS when tax-exempt bond proceeds are invested into higher yield taxable instruments resulting in a profit.
Making the profit isn't illegal if the issuer shares the upside with the federal government.
The IRS imposes yield restrictions which limits how much an issuer can earn. The yield on investments can't be materially higher than the yield on the bonds. Any excess investment earnings need to be paid back in the form of a rebate or a yield reduction payment.
Prior to 2022, issuers were typically working in a negative arbitrage landscape as the lower interest rates in the market precluded investing the money and making a profit.
"This is where we are today," said Stallings. "Short term rates are at four and a half, and last year they were over 5% so that's the positive spread we're talking about. This is a cumulative calculation for up to twenty of thirty years of your bond issue."
Arbitrage rules and exceptions are a worm can of complex disclosures, time limits, and financial reporting that if not done correctly turns into IRS audits.
Proceeds designated for special projects can shielded from arbitrage requirements. Funneling proceeds into reserve funds can also be legitimate.
Tax lawyers and bond attorneys are often called in to settle arbitrage-related
The magic number is 85% of the proceeds are expected to be spent within three years of the issue date.
Profit-making on muni issuance can also carry a stigma that goes beyond explaining things to the IRS.
"Positive arbitrage is good," said Stallings. "Focus on the low cost of borrowing. Because you've got a low cost of borrowing it means you may have to pay the positive spread to the Treasury, and it's only a slice of the interest income that you've earned. You might earn $9 million, but you only have to pay $2 million back."
The prospect of turning a profit should be tempered with clear judgement.
"I've talked with other issuers, they have an elected body that's excited about a project and they're going to go issue bonds," said Kathy Kardell, senior debt administrator, for the Office of Budget & Finance at Hennepin County, Minn.
"Don't borrow the money until you really need to. You don't sell bonds in order to try time the market."
