Investment Strategies - Swap and Collar Strategies
The main purpose behind bond swaps is to increase return.
- Substitution swap - The exchange of bonds with identical features (creditworthiness, maturity, coupon, YTM, call features) at different prices in order to exploit pricing inefficiencies. Risks include the fact that the bonds exchanged may not be perfect substitutes, gains may be realized that do not cover the costs of the transaction and the time necessary for the bonds' prices to equal one another (the workout time) may take longer and result in lower returns than required.
- Intermarket spread swap - The exchange of similar bonds with different coupons. The idea is that a change in yield could result in a price change that benefits the investor. The purchase of a bond with the higher yield could be less expensive and the sale of the lower yielding bond could generate income resulting in a net gain to the investor. However, yield changes may not rebound to the investor's benefit and the swap could result in a capital loss.
- Rate Anticipation swap - This exchange occurs in anticipation of an increase or decrease in interest rates. A rate rise would warrant a swap out of a long-term bond, which would be expected to decline in price, for a shorter-term bond which is less price sensitive due to its shorter duration. Conversely, a rate decline could warrant the sale of a short duration credit for the purchase of a longer term bond to benefit from a price increase.
- Pure yield pickup swap - This entails the exchange of a bond with a lower yield to maturity for one with a higher yield to maturity. The newer bond would have to be of a longer maturity or lower quality, making it less expensive relative to the bond sold resulting in a net gain to the investor.
- Tax Swap - Such a strategy is designed to benefit from current tax law. For example, an investor could sell a bond at a loss and repurchase the bond for the lesser amount, using the tax savings from the loss to reinvest. Investors need to avoid running afoul of the wash sale rules. With bonds, one may avoid purchasing a substantially identical security by purchasing a bond with similar characteristics from a different issuer.