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Negative Arbitrage

Candlefocus Editor
Negative arbitrage is an important financial concept, especially for borrowers in search of large-scale funding. In essence, it is the potential cost of doing business that arises when there is a decline in prevailing interest rates (the cost of borrowing) over time, the project for which funds are being held has not yet been completed, and the money is sitting in a type of escrow account. In such cases, there is a cost of not being able to take advantage of the current lower interest rate.

In simple terms, negative arbitrage describes the situation whereby the borrower loses out on the opportunity cost to hold debt proceeds in escrow over a period of time rather than reinvesting them for a return. It is essentially the difference in what the creditor makes on lending out the funds, and what the borrower would have made had they invested those funds at the new lower interest rate.

There are two main types of bonds that use negative arbitrage as a way of protection; callable and refunded bonds. Callable bonds allow the issuer to call the bond at any time, with some cost associated to the bondholder. Refunded bonds, on the other hand, are bonds that are issued to pay off an existing bond, with proceeds being kept in escrow until the new bond is issued, also with some cost added. This ensures that investors do not suffer any losses due to a decrease in the underlying value of the bond.

Negative arbitrage, can require a lot of expertise, particularly in terms of understanding market trends and the potential for interest rate changes. When it comes time for a borrower to begin a large-scale project, having a sound understanding of the risks and benefits of holding money in escrow is essential to avoiding costly mistakes. As a result, sound strategies for managing negative arbitrage can ensure that the borrower does not suffer from unnecessary losses, and is able to move forward with their project as quickly and efficiently as possible.

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