Buying & Selling Bonds

Bond Swapping

Swapping to Increase Yield

You can sometimes improve the taxable or tax-exempt returns on your portfolio by employing a number of different bond-swapping strategies. In general, longer-maturity bonds will typically yield more than those of a shorter maturity will; therefore, extending the average maturity of a portfolio’s holdings can boost yield. The relationship between yields on different types of securities, ranging from three months to 30 years, can be plotted on a graph known as the yield curve. The curve of that line is constantly changing, but you can often pick up yield by extending the maturity of your investments, assuming the yield curve is sloping upward. For example, you could sell a two-year bond which is yielding 5.50% and purchase a 15-year bond which is yielding 6.00%. However, you should be aware that the price of longer-maturity bonds might fluctuate more widely than that of short-term bonds when interest rates change.

When the difference in yield between two bonds of different credit quality has widened, a cautious swap to a lower-quality bond could possibly enhance returns. But sometimes market fluctuations create opportunities by causing temporary price discrepancies between bonds of equal ratings. For example, the bonds of corporate issuers may retain the same credit rating even though their business prospects are varying due to transient factors such as a specific industry decline, a perception of increased risk or deteriorating credit in the sector or company. So, suppose you purchased in the past (at par) a 30-year A-rated €50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are now being offered with a 6.50% coupon. Assume that you can replace your bond with another €50,000 A-rated corporate bond having the same maturity with a 6.50% coupon. By selling the first bond and buying the second bond you will have increased your annual income by 25 basis points (one basis point is 1/100th of one percent, or .01%). Discrepancies in yield among issuers with similar credit ratings often reflect perceived risk in the marketplace. These discrepancies will change as market conditions and perceptions change.

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