Arbitrage Rules and LGIP Tax-exempt Status
Municipal securities are exempt from federal income tax (and state income tax for investors who live in that state). The tax exemption means that local government entities can issue municipal bonds at rates that are lower than bonds without such a tax exemption. This gives municipal issuers an arbitrage opportunity. Specifically, local government issuers can take the money they have raised from municipal investors (who will accept a lower rate because of the federal tax exemption) and make a profit by investing the proceeds in higher paying, taxable securities. This easy money opportunity is called arbitrage.
Municipal bond issuers, however, are prohibited from issuing tax-exempt bonds with the intention of investing the proceeds at higher rates. For example, a city that issues tax-exempt bonds at 3% may be able to invest the proceeds in an LGIP that is returning 5%. In this scenario, the city would make a terrific profit (the 2% difference). But, the IRS gives municipal bonds tax-exempt status to encourage the funding of local government activities and projects, not to enrich local government.
Federal arbitrage rules aim to prevent municipalities from reaping these arbitrage benefits by removing the incentives to do so. In other words, the rules seek to limit the amount of tax-exempt bonds to what is nece