Negative Arbitrage: What It Costs and How to Reduce It

Negative arbitrage is the cost an issuer absorbs when invested bond proceeds earn less than the interest the issuer pays on the bonds that raised them.

This page explains where that cost comes from, how it is measured, and the levers the published guidance describes for reducing it; the arbitrage section covers the federal rules on the other side of the same spread.

What is negative arbitrage?

Negative arbitrage is the shortfall between the yield an issuer earns on invested proceeds and the yield it pays on its bonds, and it is a cost to the issuer rather than an excess owed to anyone.

The federal arbitrage rules target the opposite case: under 26 U.S.C. 148(a), a bond is an arbitrage bond if any portion of the issue's proceeds is reasonably expected at issuance, or intentionally used, to acquire higher yielding investments or to replace funds used to acquire them, which the yield restriction and rebate pages cover.

The Securities and Exchange Commission gave the escrow version of the idea in a 2000 order: overcharging by dealers for open-market escrow securities "takes money away from the municipality rather than the Treasury by reducing, dollar for dollar, the present value savings the municipality obtains through the advance refunding."

That order predates the 2017 federal change: under IRC 149(d)(1), interest on a bond issued to advance refund another bond is not tax-exempt, for advance refunding bonds issued after December 31, 2017.

GFOA notes that governments may still advance refund with taxable debt, so refunding escrows, and their negative arbitrage, remain part of the landscape.

Where does negative arbitrage show up?

Two settings recur in the published guidance on this cost: refunding escrows, and construction or project funds.

For arbitrage purposes, Treasury Regulation §1.148-1(b) defines a refunding escrow as one or more funds established as part of a single transaction or a series of related transactions, containing proceeds of a refunding issue and any other amounts to provide for payment of principal or interest on one or more prior issues.

The MSRB glossary describes an escrow deposit agreement as setting out how escrow funds are invested, generally in eligible securities, pending their expenditure and the schedule on which debt service payments are to be made.

That same glossary notes the proceeds of an advance refunding issue are generally invested in Treasury securities or federal agency securities, although other instruments are sometimes used.

GFOA describes the verification agent, typically a CPA firm, as confirming that the escrow is sufficient and, where yield is limited, that escrow yield does not exceed the permitted yield.

An escrow built to a fixed payment schedule, with a limited yield, can earn less than the yield the issuer pays on the refunding bonds that funded it, and that gap is the escrow's negative arbitrage.

The MSRB glossary distinguishes the structures this way:

In a crossover refunding, the escrow's earnings are doing visible work, because they are the stated source of debt service on the refunding bonds while both issues are outstanding.

Escrow pricing also draws regulatory scrutiny: the MSRB glossary defines yield burning as the sale to an issuer of securities, typically Treasuries, at above-market prices to reduce their yield to avoid arbitrage regulations, and says the SEC and IRS view the practice as illegal.

The yield burning page covers that practice separately.

Construction and project funds carry the same cost in a slower motion.

GFOA's guidance tells issuers to make certain the drawdown of proceeds is planned and recorded, and that the investment duration is no longer than the expected drawdown schedule.

GFOA's related advice on timing, not issuing well before spending begins, targets the same shortfall on the construction side; the construction fund page covers that fund in detail.

How do issuers measure the cost?

One way to size the cost in broad terms is the spread between the rate earned on the proceeds and the rate paid on the bonds, applied to the average unspent balance over the period it sits invested.

On the earned side, SLGS demand deposits take their rate from a formula: 31 CFR 344.7(a) describes them as one-day certificates that roll over automatically each day until redemption, with a rate adjusted from the average yield of the most recent 13-week Treasury bill auction for an estimated marginal tax rate of tax-exempt bond buyers and Treasury administrative costs, and any negative rate resets to zero.

For a market reference point, Treasury publishes an official par yield curve derived with a monotone convex method from indicative bid-side market price quotations, not actual transactions, collected by the New York Fed at or near 3:30 p.m. each trading day.

GFOA approaches the cost from the savings side, suggesting that governments may want a guideline that negative arbitrage is less than a certain percentage of net present value savings before a refunding is undertaken.

Its published examples of refunding policy thresholds include minimum NPV savings of 3% or 5% of refunded par, graduated thresholds such as 4% for refunded bonds with 9 or more years to maturity after call and 1% for 2 years, a minimum dollar NPV such as $100,000 or twice the costs of issuance, and a refunding-efficiency test based on call option value.

These are GFOA's examples of what a policy can contain, not requirements.

On the escrow side, the MSRB glossary describes a verification report as one prepared by a certified public accountant or other independent third party that verifies the yield of the investments held in escrow and shows the cash flow is enough to pay principal and interest on the refunded bonds.

mGIC's negative arbitrage calculator walks through this spread arithmetic for an escrow or a fund.

How can an issuer minimize negative arbitrage?

The published guidance points to three levers: how the investments are bid, how they are structured, and when bonds are sold relative to spending.

Competitive bidding

The SEC's dollar-for-dollar description is why price discipline matters in escrow and investment purchases: an overcharge comes straight out of the issuer's savings.

GFOA notes that funding an escrow with open-market securities may require an escrow bidding agent that solicits bids for the securities used in the escrow, and that a municipal advisor, if engaged, may be able to act as escrow bidding agent.

mGIC serves as Bidding Agent when issuers competitively bid investments of bond proceeds, including guaranteed investment contracts, full-flex repurchase agreements and structured portfolios of U.S. Treasury securities, following the competitive bidding process of preparing bid specifications, soliciting qualified providers, managing questions, and receiving and comparing bids on rate and non-rate terms, with its fee paid by the winning provider rather than the issuer.

SLGS demand deposits do not go through that process: 31 CFR 344.7(a) sets their rate by formula, the adjustment of the most recent 13-week Treasury bill auction average described above, rather than by competing bids.

Structuring

The MSRB glossary says SLGS are most commonly used for deposit in an escrow account in connection with the issuance of refunding bonds.

31 CFR 344.1 limits SLGS purchases to an eligible source of funds, mainly gross proceeds of tax-advantaged bonds and amounts held with them in refunding or defeasance escrows, parity reserve funds or commingled funds, plus other yield-restricted amounts; whether a particular fund qualifies is a question for bond counsel.

Under 31 CFR 344.2(e), the subscriber certifies yield, certifies that the term of the SLGS security is no longer than is reasonably necessary to accomplish the issuer's governmental purpose, and certifies eligibility so Treasury is told if eligibility ends.

Demand deposits roll over automatically each day until redemption, so the term ends when the issuer requests redemption rather than at a date set in advance.

The SEC's 2000 order, written before the 2017 change, noted ways of limiting escrow yield such as SLGS or shorter-term open-market securities followed by zero-interest SLGS.

Whether an escrow should draw on SLGS or open-market securities is a comparison of its own: SLGS or open-market securities.

Outside escrows, the MSRB glossary notes a forward delivery agreement may provide for the delivery of specific types of securities on specified future dates at fixed yields, for example to optimize the investment of a debt service reserve fund.

The SLGS and forward delivery agreement pages cover both instruments in detail.

Timing

GFOA suggests staging bond issues over the construction period and not issuing well before spending begins, which it says limits both arbitrage liability and negative arbitrage.

The same guidance applies after closing: match investment duration to the expected drawdown schedule and revisit that schedule periodically.

The draw schedule page covers building one, and the spend-down mismatch page covers what happens when draws run behind the investments.

Example: a construction fund drawn over two years

The arithmetic is easiest to see on a fund that drains on a schedule.

A refunding escrow runs the same arithmetic against savings, as in the illustrative escrow above that carried $400,000 of negative arbitrage against $1,600,000 of present value savings.

If a fund or escrow has been sitting for a while, mGIC can check your proceeds against the rules as part of a free, no-obligation reinvestment review, which looks at fund objectives, permitted investments, draw schedules, credit terms, market conditions and timing.

You can start that conversation on the contact page.

Final determinations about an issue's structure, and about its arbitrage and tax treatment, belong to bond counsel and tax counsel.

Last updated 2026-10-06.

This page is general educational information about municipal finance and federal and state rules as of the date shown. It is not legal, tax or investment advice, and it is not a recommendation about any particular investment. Product availability, legality and suitability depend on the issuer, jurisdiction, governing documents and transaction-specific facts. Final legal and tax determinations remain with the issuer's bond counsel, tax counsel and other advisors.