Buying & Selling Bonds
Swapping in Anticipation of Interest Rates
If you believe that the overall level of interest rates is likely to change, you may choose to make a swap designed to benefit or help you protect your holdings.
If you believe that rates are likely to decline, it may be appropriate to extend the maturity of your holdings and increase your call protection. You will be reducing reinvestment risk of principal and positioning for potential appreciation as interest rates trend down. Conversely, if you think rates may increase, you might decide to reduce the average maturity of holdings in your portfolio. A swap into shorter-maturity bonds will cause a portfolio to fluctuate less in value, but may also result in a lower yield.
It should be noted that various types of bonds perform differently as interest rates rise or fall, and may be selectively swapped to optimise performance. Long-term, zero-coupon and discount bonds perform best during interest rate declines because their prices are more sensitive to interest rate changes. Floating-rate, short- and medium-term, callable and premium bonds perform best when interest rates are rising because they limit the downside price volatility involved in a rising yield environment; their price fluctuates less on a percentage basis than a par or discount bond.
However, you should remember that rate-anticipation swaps tend to be somewhat speculative, and depend entirely on the outcome of the expected rate change. Moreover, shorter- and longer-term rates do not necessarily move in a parallel fashion. Different economic conditions can impact various parts of the yield curve differently. To the extent that the anticipated rate change does not come about, a decline in market value could occur.