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The Handbook of Municipal Bonds by FRANK J. FABOZZI, SYLVAN G. FELDSTEIN

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CHAPTER 16
Municipal Arbitrage and Tender Option Bonds
Bart Mosley Managing Director, Cohead of Municipal Proprietary Trading UBS Securities LLC
 
 
 
One of the most striking changes in the municipal bond market over the past two decades has been the growth of “arbitrage” programs utilizing leveraged municipal bond portfolios made possible by tender option bond (TOB) structures and hedged trading strategies to profit from relative value opportunities in the municipal market. The list of participants engaging in this activity includes the proprietary trading desks of municipal bond dealers, the investment arms of banks, hedge funds, and other alternative investment providers. Whether directly involved or not, all participants in the market are affected by municipal arbitrage activity. Municipal arbitrageurs are often the most active trading accounts in the market, providing a source of liquidity and price discovery. Also, through the use of TOBs, they provide short-term investors such as tax-exempt money market funds much needed product in which to invest.
Municipal arbitrage strategies fall into two general categories that look to profit from the well-documented372 tendency of longer maturity municipal bonds to trade at cheaper levels than would be expected by comparison to taxable fixed income investments of equivalent tenor and credit risk. One category consists of tender option bond programs that look to extract a yield premium over time as a yield spread earned over and above ...

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