Buying & Selling Bonds
Swapping for Quality
A quality swap is a type of swap where you are looking to move from a bond with a lower credit quality rating to one with a higher credit rating or vice versa. The credit rating is generally a reflection of an issuer’s financial health. It is one of the factors in the market’s determination of the yield of a particular security. The spread between the yields of bonds with different credit quality generally narrows when the economy is improving and widens when the economy weakens. So, for example, if you expect a recession you might swap from lower-quality into higher-quality bonds with only a negligible loss of income.
Standard rating agencies classify most issuers’ likelihood of repayment of principal and payment of interest according to a grading system ranging from, say, triple-A to C (or an equivalent scale), as a quality guideline for investors. Issuers considered to carry good likelihood of payment are “investment grade” and are rated Baa3 or higher by Moody’s Investors Service or BBB- or higher by Standard & Poor’s Ratings Services and Fitch Ratings. Those issuers rated below Baa3 or below BBB- are considered “below investment grade” and the repayment of principal and payment of interest are less certain. Suppose you own a corporate bond rated BBB (lower-investment-grade quality) that is yielding 7.00% and you find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding 6.70%. You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30 basis points (one basis point is 1/100th of one percent, or .01%). Moreover, during an economic downturn, higher-quality bonds, which represent greater certainty of repayment in difficult market conditions, will typically hold their value better than lower-quality bonds.
Also, if a market sector or a particular bond has eroded in quality, it may no longer meet your personal risk parameters. You may be willing to sacrifice some current income and/or yield in exchange for enhanced quality.