The term bond arbitrage refers to the practice of refinancing a higher-rate bond prior to its call date with a lower rate security. Issuing arbitrage bonds is an effective strategy when interest rates are declining.
Also known as municipal bond arbitrage, an arbitrage bond is one that is issued to take advantage of declining interest rates and bond yields. This is accomplished by refinancing a higher rate security ahead of its call date with a lower interest rate bond. In doing so, the municipality reduces their effective cost to borrow. Once issued, the proceeds from the lower interest rate bonds are typically transferred to a risk-free investment such as Treasury securities until the call date of the original bonds.
The ability to lower the effective cost to borrow is sensitive to interest rates. For example, the coupon rate of the newly issued bonds must be significantly lower than the original security. If not, the cost to issue the new bonds may be greater than the savings achieved by the refinancing process.