What is a Pure Yield Pickup Swap
A pure yield pickup swap is a transaction in which bonds with lower returns and shorter maturity rates swap for bonds with higher returns and longer maturity timeframes. The investor is swapping the lower yield bond for a bond that will give higher yields.
A bond is a fixed income investment in which an investor loans money to an entity which borrows the funds for a defined period at a variable or fixed interest rate.
BREAKING DOWN Pure Yield Pickup Swap
With a pure yield pickup swap, the sole purpose of the transaction is to increase yield. The new bonds will have a similar maturity and risk rating as the old bonds, but the coupon will change. Yield and coupon are not the same things. The yield is the income return on an investment, such as the interest or dividends received from holding a security. Whereas, a coupon is the annual interest rate paid on a bond, expressed as a percentage of the face value.
The pure yield pickup swap allows an investor to use one bond to purchase another bond which have a greater yield. For example, an investor can sell a bond with a low return and then use the proceeds from that investment to purchase a bond with a higher yield.
Bonds earn yields for investors through the coupon, from capital gains when the investment sells, and through reinvestment. Investors can use different types of bond swaps to take advantage of these different types of yields to try to improve their returns.
Other examples of bond swaps include:
- Rate anticipation swap in which bonds are exchanged according to their current duration and predicted interest rate movements. A rate anticipation swap is often made to take advantage of more profitable bond opportunities and is highly speculative.
- Substitution swap exchanges fixed-income security like a bond for higher-yielding security with a similar coupon, maturity, call feature, credit quality, or other feature. A substitution swap allows the investor to increase returns without altering the terms or risk level of the security.
- Intermarket spread swaps which exchange two bonds within different parts of the same market which is meant to capitalize on a yield discrepancy between bond market sectors.
Limitations of Pure Yield Pickup Swaps
While a pure yield pickup swap sounds like a simple and straightforward method to make money by merely exchanging more pricey bonds with low yields for lower cost products with higher yield, some considerations need be made. For instance, any bond that is less expensive and has a higher yield return generally also carries a higher risk for investors too.
In a pure yield pickup swap, the investor who has the lower yield bond has the highest amount of risk because the higher yield bond usually will be a lower credit quality. Additionally, the more extended maturity rate of the new, high-yield bond means the bondholder now has a higher amount of interest rate risk. More time to mature means more time and opportunity for interest rates to change unfavorably. In general, a bond’s price will drop when interest rates rise.