Bond Trading Strategies and Bond Swaps

Stoever Glass Wealth Management
Roland Stoever
30 Wall Street
New York, NY 10005
800-223-3881
[email protected]
www.stoeverglass.com
Bond Trading Strategies and Bond Swaps
September 01, 2015
Page 1 of 4, see disclaimer on final page
Bond Trading Strategies and Bond Swaps
Active bond investing strategies
Rather than pursuing a passive bond investing strategy, some investors trade bonds to try to profit from changes in interest rates,
differences in yields, or perceived mispricing in the marketplace. Such strategies are often pursued by means of bond
swaps--exchanging one bond for another or one type of bond for another. In some cases, investors swap bonds for very
straightforward reasons. For example, you might prefer the relative safety of a Treasury bond to a corporate bond, or want the
higher yield of a junk bond despite its greater risk. However, you can also use a bond swap to try to increase yields, or minimize
capital gains taxes or interest-rate risk.
Caution: Transaction costs involved with any bond swap can reduce any potential financial gain.
Pure yield pickup swaps
A pure yield pickup swap is perhaps the simplest type of bond swap. Generally, the yield on longer-term bonds is higher than that
on shorter-term bonds. Why? Because the longer a bondholder must wait for the bond's principal to be repaid, the greater the risk
compared to an identical bond with a shorter maturity. Investors demand more reward in return for this greater risk. With this type
of swap, you would sell short-term bonds and buy long-term bonds with a higher yield, thus increasing your income. A pure yield
pickup swap involves no speculation about the changes in interest rates, the yield curve, or credit ratings.
Tax swaps
In order to reduce your overall capital gains and the corresponding capital gains tax liability, you could engage in a tax swap. With
this strategy, you would sell at a loss bonds that have decreased in value, perhaps because of rising interest rates. The loss could
be used to offset gains. To complete the swap, you would use the proceeds from the sale to purchase new bonds of similar quality
and maturity.
Yield spread strategies
The difference between the yields of two different bonds or types of bonds is called the yield spread. Some investors use the yield
spread to try to profit from changes in interest rates or bond market fluctuations.
Riding the yield curve
In some cases, you may be able to increase the return on short-term investments by systematically taking advantage of the yield
spread between short- and long-term maturities.
The yield curve compares the yields of similar securities with various maturities. Typically, that line slopes upward as maturities
lengthen and yields increase. The more difference between the yields on 3-month T-bills and 30-year bonds, the steeper the yield
curve. The yield curve doesn't always slope upward; it can be flat or even inverted if short-term rates exceed those for longer
maturities.
However, when the yield curve does slope upward and doesn't change dramatically during your investment time frame, a strategy
called riding the yield curve may be used. As yields on long-term bonds get closer to their maturity date, their yields begin to drop
toward the levels of shorter maturities; the yield on a 10-year bond that's only two years from maturity might be similar to that of a
2-year note. At the same time, however, its price would rise, because bond prices move upward as their yields drop. If that
happens, you might be able to sell the 10-year bond for more than you paid for it.
Example(s): You have $10,000 that you want to invest in an income security for two years. You could buy a 2-year Treasury note
that matures when you want your principal returned. Or, you could buy a new 5-year Treasury note, hold it for two years, and sell
it before maturity. Assuming the yield on the 5-year note is higher than that of the 2-year note, you could ride the yield curve by
benefitting from both the longer maturity's higher yield and the gain in the bond's value as its yield falls over time.
Caution: This strategy should only be used if the yield curve slopes upward and is expected to remain stable as long as you hold
the bond. If interest rates fall and bond prices rise, the yield could be higher than you expected. However, if interest rates rise and
the yield curve flattens or inverts, the benefit of this strategy would be reduced. You might not earn any more than if you had
September 01, 2015
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simply bought a shorter maturity, and you could even lose money or be forced to hold the bond longer than you had anticipated
hoping to avoid a loss.
Caution: Keep in mind that strategies that involve selling one bond and replacing it with another will incur transaction costs, which
could reduce any potential financial gain.
Substitution swaps
In a substitution swap, you sell a bond and replace it with another bond having similar characteristics (e.g., the same maturity,
coupon rate, and credit rating) but a different yield--typically, a higher yield that would increase your overall return. You might
perform a substitution swap if you feel a bond might have potential for price appreciation because it is mispriced--for example, if
you feel its credit rating is too low and may be raised.
A similar yield spread strategy, called the intermarket spread swap, occurs when an investor believes one type of bond is
temporarily mispriced relative to another type. This swap would involve selling one type and buying another (e.g., replacing a
government bond with a corporate bond with a similar maturity and coupon rate) in the belief that the prices of the two will change
at different rates and one might potentially be more profitable than the other.
Example(s): Assume the yield spread between corporate bonds and Treasuries is wider than usual, meaning investors feel less
secure about the creditworthiness of corporate bonds generally and are demanding greater yields. Let's also say that you believe
the economy will begin expanding soon, reducing corporate credit risk. You might choose to replace some of your Treasury
holdings with corporate bonds to try to profit should corporate bond prices rise faster than those of Treasuries. Conversely, if you
believe the economy will slow and the yield spread between corporates and Treasuries will increase because investors will be
drawn to the security of Treasuries, you might exchange some corporate bonds for Treasuries to reduce the potential for price
loss should the yield spread widen and corporate bond prices drop more quickly than Treasury prices.
Rate anticipation swaps
A rate anticipation swap requires some speculation on your part. However, if it's successful, it could allow you to take advantage
of (or avoid the undesirable consequences of) future rate changes. If you anticipate an increase in rates, you could swap your
long-term bonds for ones with shorter maturities whose prices will not change as dramatically. That would reduce your portfolio's
duration. If you believe rates will fall, you could swap short-term bonds for long-term bonds, increasing the duration of your
portfolio to try to lock in higher yields.
Caution: If you guess incorrectly, the financial impact of the rate change will be magnified as a result of your swap.
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IMPORTANT DISCLOSURES
Stoever Glass Wealth Management,, Inc. does not intend the information provided to give individual
investment, tax, or legal advice. The information presented here is not specific to any individual's
personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and
cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
Each taxpayer should seek independent advice from a tax professional based on his or her
individual circumstances.
These materials are provided for general information and educational purposes based upon publicly
available information from sources believed to be reliable—we cannot assure the accuracy or
completeness of these materials. The information in these materials may change at any time and
without notice.
Stoever Glass Wealth Management
Roland Stoever
30 Wall Street
New York, NY 10005
800-223-3881
[email protected]
www.stoeverglass.com
Page 4 of 4
September 01, 2015
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2015