Intro to Bond Swaps

Here is a strategy you may have heard of: bond swaps. There are a number of reasons to do a swap, and here are some of them.

There are a number of types of bond swaps available, so you don’t need to be a sophisticated bond investor, or a large portfolio investor to take advantage of a swap.
A bond swap occurs when an investor sells a bond issue and then immediately purchases another bond issue from the proceeds of the sale. Why would I want to execute a bond swap? Here are some reasons you might want to consider a swap.
·         Increase the credit quality of your bond portfolio
·         By swapping into higher yielding bonds your total return increases
·         Benefit from interest rate changes
·         Lower your taxes
Let’s begin with a quality swap. A quality swap is exactly what it sounds like. You are swapping out of one issue with one rating and purchasing the opposite rating in a different bond. Here is an example. Let’s imagine you have ten B rated bonds and you decide to sell them and with the proceeds purchase ten AA rated bonds; that is a quality swap. When the economy was quite bad you may have decided to invest in high yield bonds because the spread between junk (high Yield) and high quality AA rated bonds was significant. However, now that the economy is showing signs of a recovery the credit spread narrows drastically. You may decide that the difference between junk and investment grade is no longer worth the risk for staying with junk or high yield bonds. You sell your high yield bonds and purchase investment grade ones instead.  On the other hand if you are concerned with holding lower quality bonds during a recession you can do the swap early on and realize very little loss of income. During an economic downturn your higher quality bonds will hold their value better than an issue rated below BBB or Baa. 
You may also want to do a swap in order to capture a higher yield. Maybe you have a certain income target you would like to reach and the way to do it is through going to below investment grade on several of your bond issues. If you are not comfortable with a lower yield bond think about lengthening the maturity of the bonds in your portfolio. You may find that by adding ten years to the maturity of the bonds you are holding, bumps up your return enough to make the trade worthwhile. Newer investors may be tempted to rush out and purchase thirty or forty year bonds before taking a look at the yield curve. In general, in a normal market where the yield curve is not inverted, the longer you hold the bond the higher the rate. Because your money is at risk longer you are compensated by having a better rate on a long bond as opposed to a short one. 
If you look at recent yield curves you will find that a thirty year bond yields little to know difference in rate over a sixteen or seventeen year bond. Why risk your money for another thirteen or fourteen years if you are not compensated for the risk? I would stop at the peak of the curve and adjust accordingly. So, what happens if I need to buy a 13 year bond but there are only ten and twenty year ones being issued? You simply purchase them on the secondary market. You look for a twenty year bond that was issued seven years ago and has only thirteen years left on it. If you are having difficulty with this, your broker should be able to find what you are looking for quite easily.
Just remember that while you are swapping out your short bonds for longer issues, your overall portfolio is going to be significantly more volatile. This of course may not be an issue if you are holding the bonds until maturity. You might consider swapping out of your AA bonds and into BB bonds to capture that difference in yield.
You may also want to swap to increase your call protection. If we are in an environment where rates are continuously falling, your callable bonds my get called on the first opportunity they get. If that happens you are suddenly stuck with a lot of cash and nowhere to put it that has that same yield you had been enjoying. You may be able to sell your bonds with five years call protection in favor of issues with ten years call protection. Keep in mind that you may have to sacrifice a little in yield for that longer call protection.
So there are just a few strategies involving bond swaps.
Good luck and happy investing.

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