What Is a Pure Yield Pickup Swap?
A pure yield pickup swap is the practice of exchanging one set of bonds for another, with the intention of increasing the yield received on those bonds. Importantly, the term assumes that the increase in yield will not be achieved at the expense of increasing the riskiness of the bonds.
Typically, this swap will involve selling bonds with relatively short maturities and purchasing bonds with relatively long maturities, since longer-maturity bonds generally offer higher yields.
- A pure yield pickup swap is a strategy that involves selling short-maturity bonds in exchange for longer-maturity bonds.
- The purpose of the strategy is to increase the total yield of the bond portfolio.
- Investors who use the pure yield pickup swap strategy will seek to ensure that the new bonds they purchase have the same or superior credit quality compared to the bonds they have sold.
How Pure Yield Pickup Swaps Work
Generally speaking, bond investors who want to increase the yield received on their bonds have two main ways of achieving this goal. Either they can exchange their bonds for riskier but higher-yielding alternatives, or they can extend the average maturity period of their portfolio. By swapping bonds with short maturities for bonds with relatively long maturities, investors may be able to increase the yield on their portfolio without significantly increasing the risk of their holdings.
When considering how to implement a pure yield pickup swap, investors must be careful to ensure that the new bonds they are purchasing have a similar risk profile as the bonds they are selling. For example, if an investor is selling 5-year corporate bonds and seeking to purchase 10-year corporate bonds, they should ensure that the issuer of the 10-year bonds is not at greater risk of bankruptcy or default as the issuer of the 5-year bonds. One simple way of achieving this goal is by swapping bonds that are issued by the same issuer, such as if the same corporation were issuing the 5- and 10-year bonds in the example above.
When evaluating a potential pure yield pickup swap, investors will need to consider whether the additional yield received on the longer-maturity bonds is sufficient to compensate them for the additional risks associated with a longer maturity period. These include interest rate risks, inflation risks, and the risk that the issuer may default on their debts. Shifting their portfolio toward relatively long-maturity bonds might also decrease the investor’s liquidity, making them less able to respond to any unanticipated future shocks.
Other Types of Swaps
Other approaches used by bond investors include rate anticipation swaps, in which bonds are exchanged according to their current duration and predicted interest rate movements; substitution swaps, in which bonds with very similar characteristics are exchanged such that the total risk level is not affected; and intermarket spread swaps, where investors seek to exploit a discrepancy in yield between two bonds within different parts of the same market.
Example of a Pure Yield Pickup Swap
Dorothy is a successful entrepreneur who recently received $2 million in cash for the sale of her business. To plan for her retirement, she invested the full proceeds of the sale into corporate bonds issued by XYZ corporation.
At the time of her purchase, XYZ bonds offered a yield of 3.75%, which was sufficient to give Dorothy a comfortable retirement income. Since then, however, Dorothy has decided to undertake a more active investment stance and is therefore seeking ways to further increase the yield on her bond portfolio. She decides to carry out a pure yield pickup swap, trading her XYZ bonds for a comparable but longer-maturity instrument that will offer a higher yield.
To decide which new bond to purchase, Dorothy begins by studying companies with similar credit ratings at XYZ. To help make her decision with greater confidence, Dorothy restricts her research to industries that she is personally familiar with, in order to better judge the accuracy of the credit reports. She identifies three bonds, each issued by competitors within XYZ’s industry, that offer longer maturities than her existing XYZ bonds. If she swaps her XYZ bonds for these new securities, Dorothy estimates that she can increase her total yield to 4.50%.
Dorothy is satisfied that the issuers of the three new bonds have similar or superior financial strength as XYZ, and should therefore not pose any greater credit risk. Moreover, she feels that the additional yield offered by these bonds is adequate compensation for the increased interest rate, inflation, and liquidity risk represented by their longer maturities. Based on this analysis, she decides to execute the pure yield pickup swap, selling her XYZ bonds in exchange for the bonds from the three new issuers.