Bond Trading Strategy: Swapping

Ah, if only the world would stand still - just for a little while. But, in the world of investing (as elsewhere) it's never so.

Forecasts made on purchasing day have to be adjusted tomorrow in light of changing circumstances and new discoveries. Keeping up with those changes - or, better still, anticipating them, is what bond trading strategy is all about.

First considerations in bond selection are, of course, price and yield. Price is what you pay, yield is what you earn based on a bond's interest rate (coupon), current price and remaining years to maturity.

For example, a bond selling 'at par' for $1000 with a coupon of 5% pays interest of $50 per year. Excluding issues of tax or inflation, the current yield is $50/$1000 = .05 = 5%. Not surprising. Nothing has changed from day one.

Now, suppose interest rates have risen to 7% since the bond was first sold on the secondary market. The price of that bond will fall ('sell at a discount'), to say 98. (Bond prices are quoted as a percentage of the face value. 102 is 2% above par, 98 is 2% below par.) So, $1000 x .98 = 980. 50/980 = 0.51 = 5.1%.

Such calculations (and those more complicated, made easier by use of one of the many Internet available calculators designed for just that) are essential to forming a bond strategy.

So, assume the calculations are done. Now what?

You've looked around the rest of the market and now believe you can get a better deal elsewhere. You can sell outright or you can execute a swap.

A swap involves selling one bond, then immediately buying another with the funds. (The investor never sees the details of the exchange.) Why bother?

Based on calculations, investors form projections. Those projections involve estimates of interest rate changes, changes in personal tax circumstances or general tax rates and laws, alterations in investment objectives or tolerance for risk and so on.

Changing interest rates may make a 5% bond no longer attractive to hold. Rising rates yield higher payments from another. Fallen rates cause the sale price to increase giving an opportunity for capital gains.

Companies' fortunes wax and wane and the credit risk associated with a particular issue change accordingly. A bond rated A (borderline investment grade) can dip to B or worse. That risk level may be unacceptable to one investor but fine with another.

Individuals retire, get promotions and inheritances, get lucky in the stock market, etc. Those changing financial and personal circumstances bring with them changes in tolerance for risk. Someone with substantially more capital may be more willing to speculate on a borderline high-yield bond. Retirees may want to lock in predictable interest payments from one more secure.

Swaps are one way to manage changing circumstances and predictions.

Swaps can be carried out without realizing immediate capital gains - hence no tax liability. (There are exceptions; see your tax adviser.) For someone in a 33% tax bracket, that's attractive. To a retiree with a now much lower income (and tax burden), the pros and cons will differ.

All these changes, and more, produce trading partners for swaps. All those swaps make possible adjustments of risk, tax liability and other factors to increase return or minimize exposure.

In a complicated world, having one more strategy never hurts.