Bond Swaps: Optimizing Bond Portfolios
In simple terms, a bond swap is when an investor chooses to sell one bond and subsequently purchase another bond with the proceeds from the sale in order to take advantage of the current market environment. Investors may choose to swap a bond for a wide variety of reasons including:
- Anticipation of a Change in Interest Rates
- Extend or Shorten Maturity
- Alter Call Protection
- Capture a Premium
- Alter Credit Quality or Change Industries
- Lower Taxes
Anticipation of a Change in Interest Rates
Investors who believe interest rates are likely to change may choose a swap designed to benefit from, or protect against, potential changes in bond prices. If interest rates are expected to decline, investors typically extend the duration or maturity of their holdings and may consider increasing their call protection. Bonds with higher duration and longer maturities are more sensitive to changes in interest rates and should rates decline, bonds with these characteristics can be expected to rise more than shorter-term bonds. On the other hand, if rates are expected to increase, investors may decide to reduce duration and maturity and look to decrease the call protection in their portfolios. Shorter-term bonds, those with lower duration and less time to maturity, are less sensitive to changes in interest rates and should fluctuate less in value. It is important to note that a swap in anticipation of a change in interest rates is somewhat speculative, and will be at the mercy of the actual outcome of the anticipated rate change. Additionally, short and long-term rates do not necessarily move in tandem and different economic conditions may impact various parts of the yield curve differently.
Extend or Shorten Maturity
A basic extension swap could be one of two scenarios: sell a shorter-term bond and purchase a longer-term bond, thus providing increased yield or income as the investor moves out on the yield curve; or sell a longer-term bond and swap it for a shorter-term maturity, thereby reducing price sensitivity should interest rates move upward. Extending maturity with the intent of reaping potential profits is a speculative move, as no one can be certain where the market is heading and in what timeframe. A misjudgment of interest rates can have a significantly negative impact on the value of a bond portfolio, especially if the portfolio’s average duration is relatively high. Longer-term bonds typically have greater price sensitivity to changes in prevailing interest rates relative to their shorter-term counterparts, and swapping away from shorter term bonds may forfeit any reinvestment opportunities.
Alter Call Protection
Investors may swap bonds with the goal of increasing their call protection (especially if rates are declining and the likelihood of a call increases), or to decrease call protection (should interest rates be headed higher and the odds of a call decrease). Callable bonds typically carry higher yields than similar non-callable bonds to compensate investors for the uncertainty of a possible call. Note that a call is at the option of the issuer and may or may not occur depending on other issuer-specific circumstances.
In a low interest rate environment, many bonds have appreciated substantially and are currently trading at high premiums. Even if interest rates remain unchanged, this premium will slowly disappear as a bond naturally approaches maturity and is subsequently redeemed at par value. An investor can sell the bond with a premium, potentially capturing the gain, and then roll the proceeds into another suitable issue with a similar yield that is priced closer to par. By doing so, the investor may own more bonds than they originally purchased due to the capturing of the original premium.
Alter Credit Quality or Rotate between Industry Sectors
Depending on market conditions, this type of swap occurs if an investor wishes to move from a deteriorating credit into a stable or improving credit. Conversely, should an investor see an attractive risk/reward opportunity they may choose to move away from a higher quality credit into a lower quality name that may eventually improve. A credit rating is a general measurement of an issuer’s financial health, and thus its ability to repay its debts. Similar to a credit quality swap, if a market sector or industry has eroded in quality, an investor may choose to swap based on this change alone. Swapping from a weakening sector into one with more stable prospects may help clients stay within their individual risk tolerances. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency.
Swapping to Lower Taxes
This type of swap is the most difficult as there are many rules and regulations associated with tax-loss swapping, such as minimum holding periods, treatment of OID or market-discount, avoiding wash sale rules, etc. - all of which should be evaluated prior to making a decision to swap. In a tax swap, a "paper" loss will be converted to a real loss that can be used to offset, without limit, capital gains and up to $3,000 of ordinary income per year on a joint return. Note that losses which are unused one year may be carried forward indefinitely to reduce ordinary income and capital gains liability in future years. Investors should consult with their tax advisors when considering any type of tax-swap action.
Swapping: How to Avoid a “Wash Sale”
When an investor engages in a bond swap for tax purposes they must be careful to work within the rules set forth by the IRS. The IRS will not allow a tax loss from the sale, and subsequent repurchase, of the same or “substantially identical” security within 30 days. Doing so would generate a “wash sale” and the investor would not be able to book a loss for tax purposes. Although the term “substantially identical” is not strictly defined, bonds that carry a differing issuer or materially different maturity or coupon rate tend to be exempt from the “wash sale” rule. Investors should consult a professional tax advisor for additional details.
Is it Time for a Bond Swap?
The versatility of bond swapping methods provides ample opportunities for investors to improve their bond portfolios (credit quality, sector, yield) or to opportunistically position for an anticipated change in market conditions (modify extension, duration, call protection, tax-swaps). Professional advice and, in many cases, professional management are key elements of successful financial planning. Our Financial Advisors assist investors in creating diversified fixed income portfolios designed to perform well in unpredictable market environments while addressing the investors’ specific objectives for level of income and principal preservation. As investors reevaluate their bond portfolios, they should run through a brief list of questions to help determine if it is the right time to consider a bond swap.
- Are you looking to capture a gain or realize a tax loss?
- Would you like to improve the credit quality of your portfolio?
- Do you wish to increase your yield or income?
- Would you like to have more call protection?
- Has your tax status changed?
- What is your current tax bracket?
- What are your general investment parameters, and have they changed?
An overview of risks and other factors is available from the following sources: ‘What you need to know about the risks of bond investing’ link referenced above, on finra.org, emma.msrb.org, and investinginbonds.com. Asset allocation and diversification do not ensure a profit or protect against a loss. Investment suitability must be determined for each individual investor.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Past performance is no assurance of future results.
This communication is intended to improve the efficiency with which Financial Advisors obtain information relevant to their client's taxable fixed income holdings. This information should not be construed as a directive from the RJ&A Taxable Fixed Income Department to buy or sell the securities noted above. Prior to transacting in any security, please discuss the suitability, potential returns, and associated risks of the transactions(s) with your client. For additional disclosure information on any security listed in this publication, please contact a Raymond James financial advisor.
The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Trading ideas expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Investors are urged to obtain and review the relevant documents in their entirety. RJA is providing this communication on the condition that it will not form the primary basis for any investment decision you may make. Furthermore, because these are only trade ideas, investors should assume that RJA will not produce any follow-up. Employees of RJA or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. RJA and/or its employees involved in the preparation or the issuance of this communication may have positions in the securities discussed herein. Securities identified herein are subject to availability and changes in price. All prices and/or yields are indications for informational purposes only. Additional information is available upon request.
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