Negative Arbitrage

Negative Arbitrage

What it is

Negative arbitrage is an opportunity cost that occurs when a bond issuer holds proceeds from a debt offering in an escrow account (typically invested in cash or short-term Treasuries) and the return on those investments is lower than the interest the issuer must pay on its debt. In short: the borrower’s cost of borrowing exceeds the return earned on the funds set aside to repay that borrowing.

How it happens

Negative arbitrage commonly arises in two situations:
* When an issuer raises funds but cannot immediately use them (e.g., project financing) and prevailing market rates fall, so the escrow investments earn less than the coupon on the issued debt.
* During a refunding (refinancing) of higher-coupon, callable bonds with new lower-rate bonds. Proceeds from the new issue are held in escrow until the old bonds become callable; if escrow investments yield less than the old bonds’ coupon, an issuer incurs negative arbitrage.

Example:
A state issues $50 million in municipal bonds at 6%. Proceeds sit in a money-market account paying 4.2% for a year while the project is prepared. The issuer effectively loses 1.8% on those funds—the negative arbitrage—reducing available project dollars.

Negative arbitrage in refunding bonds

When existing callable bonds are refunded:
* The issuer issues new (refunding) bonds at lower market rates.
* Proceeds are invested in Treasury securities and held in an escrow until the call date on the old (refunded) bonds.
* If the yield on the escrowed Treasuries is lower than the coupon on the refunded bonds, the issuer faces negative arbitrage.

Consequences:
* The escrow must generate the same debt-service cash flows as the outstanding bonds. If Treasuries yield less, more principal must be placed in escrow, increasing the size (and cost) of the refunding issue.
* In severe cases, negative arbitrage can make an advance refunding uneconomical.

Simple measure

Negative arbitrage ≈ coupon (or cost of old/new debt) − yield earned on escrowed investments.
This represents the annual percentage point loss on escrowed funds while they await use.

Effects on issuers and projects

• Reduced funds available for the intended project or higher total borrowing costs.
• Larger refunding issues or the cancellation of an intended advance refunding if the escrow shortfall is too large.
• Potentially worsened borrowing economics despite lower headline interest rates on new debt.

Mitigation strategies

Issuers can take several steps to reduce or avoid negative arbitrage:
* Time refundings closer to the call date to minimize the escrow period.
* Use callable structures and refund only when savings outweigh expected negative arbitrage costs.
* Invest escrowed proceeds in higher-yielding but appropriately safe instruments (subject to legal and credit constraints).
* Use forward-delivery securities or other hedging tools to lock in better yields for the escrow period.
* Structure refundings so debt-service matching requires less excess principal in escrow.

Key takeaways

• Negative arbitrage is the lost return when escrow investments yield less than the cost of outstanding debt.
• It commonly appears when interest rates fall after issuance or during advance refundings.
• It can increase the effective cost of borrowing or make refundings uneconomical.
• Careful timing, investment selection for escrow, and refunding structure are the main ways issuers manage negative arbitrage.