Municipal bonds serve as the foundation of infrastructure development, providing tax-exempt returns to investors while fueling the construction of essential projects across our communities. These bonds, once issued, also create opportunities for the issuers to generate potential arbitrage opportunities.
With the Federal Reserve increasing interest rates over the last few years to ease inflation, this has produced an attractive opportunity for bond arbitrage, and one that needs to be carefully managed.
Traditionally, the primary concern for bond compliance focused on ensuring the proceeds from a bond issuance are used for qualified governmental purposes. This remains a critical aspect, but the current high-rate environment adds a new layer of complexity. With the yield curve being inverted for over 20 months now, positive arbitrage and yield restriction payments almost seem like an inevitability.
Yield Restriction and Arbitrage Rebate
Municipal bonds offer tax-exempt interest, typically attracting lower yields compared to taxable investments. However, this tax benefit creates a critical rule: yield restriction. This regulation prohibits issuers from investing bond proceeds in assets with a yield exceeding the restricted yield (bond yield + up to .125%) for the bond.
Section 148 of the Internal Revenue Code of 1986, was created specifically to limit the issuers ability to exploit the difference between tax-exempt and taxable interest rates, also known as arbitrage.
Along with clearly defining the rules around arbitrage rebate, the IRS also created specific rules around yield restriction – allowing temporary periods, small issuer exemptions, bona fide debt service funds, and scenarios around reserve funds to help issuers generate reasonable arbitrage. While these opportunities do exist, they do still require strict adherence to IRS rules and regulations and regular reporting requirements.
The Challenge of Higher Yields
An inverted yield curve occurs when short-term interest rates, like those on T-bills, are higher than long-term interest rates, like those on long-term municipal bonds. This is a departure from the typical upward slope of a yield curve, where longer maturities offer higher returns.
Since municipal bond arbitrage relies on the ability to invest bond proceeds (typically tax-exempt) at a rate exceeding the borrowing cost of the bond, an inverted yield curve with high short-term yields disrupts this strategy in a sense that it now brings bond yield restriction into play.
With the Federal Reserve’s recent announcement to maintain the current fed fund rate for the present moment, we can expect the inverted yield curve to remain in play for the foreseeable future – possibly into late 2025.
What this means for municipal bond issuers is that extra attention needs to be paid to maintain bond compliance and complete calculations for any arbitrage rebates or yield reduction payments due to the IRS.
What Should I Do Next?
Today’s high-rate environment is creating situations where investments allocated to a bond issue are growing faster than the bond itself. When allocated bond proceeds exceed the bond issue’s value, universal cap rules force a de-allocation of proceeds, starting with the often more conservatively invested debt service funds. Without a proper understanding of a project’s progress – in regard to both spending and time – an issuer can rack up a liability they may be unable to pay. That’s why it is so important to have an arbitrage expert in your corner.
While a higher Fed Funds Rate can present challenges for municipal bond compliance, it also offers some opportunities for issuers. By carefully planning investment strategies, understanding arbitrage regulations, and maintaining open communication with your bond compliance specialists, issuers can ensure their municipal bond offerings remain a valuable financing tool for public projects.
If you need assistance navigating the complexities involved with your municipal bonds, please reach out to our bond compliance specialists today. Our team at ACS has decades of experience navigating the complex IRS regulations to ensure your bonds remain compliant and your tax-exempt status remains secure.