By Tami Olszewski, Senior Investment Adviser
and Stephen Broden, Director of Arbitrage Consulting

Unlocking the Power of Tax-Exempt Investment Vehicles

Municipalities, possibly your community, may be sitting on unspent bond proceeds earning interest above the allowable arbitrage yield. While this may seem like a short-term win, it can trigger a long-term IRS rebate liability. Fortunately, there’s a compliant, strategic way to manage this liability through the use of Demand Deposit SLGS (State and Local Government Series Securities) and Tax-Exempt Municipal Debt Obligations. With the right guidance, issuers of tax-advantaged debt can protect themselves and their funding flexibility.

Understanding Arbitrage Liability

Arbitrage occurs when municipalities invest tax-exempt bond proceeds in higher-yielding investments. If the return on these investments exceeds the bond’s arbitrage yield, the excess earnings—known as arbitrage earnings—may need to be rebated to the IRS. Even temporary investments in higher-yield vehicles can create long-term complications. The IRS requires issuers to monitor and report these earnings, and failure to comply can jeopardize the tax-exempt status of the bonds.

If you have unspent bond proceeds from a tax-exempt bond issuance, it’s critical to monitor and track your arbitrage rebate liability to remain compliant with IRS regulations. To facilitate this, issuers are required to file IRS Form 8038-T to report and remit any arbitrage rebate or yield reduction payments- if any exist. This filing must occur at least every five years while the bonds are outstanding, and potentially more frequently depending on the bond covenants and investment activity. These rules are complex, and if you are not fully aware of all exemptions or mitigation strategies available to you, you may be missing out on additional income.

There are two tax-exempt strategies that may allow you to retain income earnings, instead of rebating to the IRS.

Demand Deposit SLGS are U.S. Treasury securities tailored for state and local governments. They are yield-compliant, IRS-approved, and designed to help issuers manage arbitrage exposure.

Key features include:

• Daily liquidity: Funds can be accessed at any time.
• Flexible terms: Issuers can tailor maturities to match project timelines.
• Automatic compliance: SLGS are exempt from arbitrage rebate and yield restriction, simplifying tracking and reporting.

In addition to Demand Deposit SLGS, certain tax-exempt municipal debt obligations may also offer strategic advantages for managing arbitrage exposure. Under IRS rules, investments in tax-exempt municipal bonds—such as those issued by other governmental entities—are not considered “investment property” for arbitrage purposes, provided they are not subject to the Alternative Minimum Tax (AMT).

Key features include:

• Earnings from these investments are not subject to yield restriction or rebate requirements under IRC Section 148.
• They may qualify as purpose investments if aligned with the governmental use of the bond proceeds.
• They can be used to preserve tax compliance while potentially offering higher yields than SLGS.

However, issuers must ensure that these investments meet specific criteria and are properly documented. Misclassification or improper allocation could still trigger arbitrage liabilities. Consulting with an experienced adviser is essential to determine whether these instruments are appropriate for your situation.

Use Case: Lowering Arbitrage Yield on Unspent Proceeds

An example: A city with $12.8 million in unspent bond proceeds was earning 4.18% in a Local Government Investment Pool (LGIP), while the arbitrage yield was 2.005%. Using these figures, the city would ultimately earn $1.285 million in interest income, but would owe $701k in arbitrage rebate. The rebate would need be paid out at the end of the project.

By shifting all $12.8 million of bond proceeds into DD SLGS, earning 3.35%¹, the city would:

• Reduce weighted average yield from 4.18% to 3.35%.
• Lower arbitrage rebate from $701k to $0.
• Maintain liquidity the same liquidity as it had with LGIP investments
• Increase net investment income by $420k.

By the math, the city would spend the remaining amount within one year with equal spending every other month:

 1) Like the example taxable yield above, the DD SLGS yield will change over time, this is the current annualized yield as of June 11, 2025.

If you have unspent proceeds and you’re unsure about your arbitrage position, especially if you are approaching the first five-year mark, now is the time to act. Contact your Ehlers Investment Adviser to discuss. Let Ehlers help you put those dollars to work—strategically and safely.

Required Disclosures: Please Read

Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an investment adviser registered with the SEC; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.

This communication does not constitute an offer or solicitation for the purchase or sale of any investment (including without limitation, any municipal financial product, municipal security, or other security) or agreement with respect to any investment strategy or program. This communication is offered without charge to clients, friends, and prospective clients of the Affiliates as a source of general information about the services Ehlers provides. This communication is neither advice nor a recommendation by any Affiliate to any person with respect to any municipal financial product, municipal security, or other security, as such terms are defined pursuant to Section 15B of the Exchange Act of 1934 and rules of the MSRB. This communication does not constitute investment advice by any Affiliate that purports to meet the objectives or needs of any person pursuant to the Investment Advisers Act of 1940 or applicable state law. In providing this information, The Affiliates are not acting as an advisor to you and do not owe you a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934. You should discuss the information contained herein with any and all internal or external advisors and experts you deem appropriate before acting on the information.