Bond swapping refers to the process of selling a bond and using the proceeds from the sale to buy another bond to achieve a certain investment goal. There are many reasons why investors perform bond swapping. The following are the main reasons and the advantages of bond swapping.
This is arguably the most common reason behind bond swapping activities: lowering the capital gains taxes or ordinary income tax. Bond swapping to reduce taxes involves the sale of a bond that is trading lower than the price that you paid to buy the instrument and taking the loss to write-off a part or all of the taxes owed on capital gains from other investments or ordinary income.
Simultaneously, you would have to buy another bond investment with similar but different features such as yield, credit rating, and maturity. By swapping bonds in this situation, you have the chance to both write-off a loss in order to save on taxes and reinvest in another similar instrument that may hold its value and realize the anticipated return upon maturity. This lets you gain profits later.
For Greater Yield
There are investors who want to increase the potential return through their bond investments. And they usually engage in bond swaps by doing the following:
Investors will usually swap a shorter-term bond for a longer term bond because longer term bonds usually offer higher yields. More commonly, long bond maturity means greater yield. When swapping to increase yield, it’s very important to remember that prolonging the maturities could make your investments more vulnerable to price volatility if interest rates are changed.
Credit Quality Lowering
Since bonds with lower credit ratings usually make up for that by giving higher yields, a person may carefully swap a higher quality for a lower quality in order to gain a greater return.
Adapting to the Changing Conditions
Bond swapping may also be considered if there are changing conditions within an industry or the broader market is compelling issuers to offer higher coupon rates and lower prices for the similar bonds that are already allocated in your portfolio.
The credit rating of a bond is usually one of the most important factors for an investor. Investors swap bonds to improve quality by selling one fixed income holding with a lower credit rating for another one, similar to the former, with a higher credit rating.
This is particularly appealing to investors who are worried about a potential downturn within a certain market sector or the broader economy. Such downturns can potentially affect the bond holdings that have lower credit ratings.
Swapping with higher rated bonds may be an easier way to gain greater confidence that the bond investment will have a higher probability of being repaid. This comes in exchange of a lower yield.
Due to Interest Rate Changes
Since bonds offer fixed rates of interests, the holders can easily compare potential gains or losses because of interest rate environment changes.
For instance, if you are expecting an increase in interest rates, you may want to consider swapping longer-term bond holdings for shorter-term bonds to lower the potential impact on your overall bond portfolio value.
In the same fashion, if you are concerned about interest rate decrease, you may decide to extend the average maturity of your portfolio.