The Advantages of Bond Swapping
Original post by Alexander Newman of Demand Media
Investors swap out bonds by selling an existing bond, while at the same time using the proceeds of the sale to buy a different bond. This can be done for a variety of reasons, such as for tax purposes or for a change in investment strategy. A bond acts similar to a loan, because companies and governments that sell bonds to raise money for their operations will owe the bondholder interest at regular time intervals until the bond matures. At this point, the bondholder can redeem from the debtor the original amount borrowed.
Bond investors can lower their tax burden at the state and federal level through swapping, because unrealized gains and losses do not count for or against income for tax purposes until the investor sells the bonds. An investor can choose to sell an underperforming bond below its purchase price in order to take a loss and then purchase another bond that the investor believes will appreciate in the future. The loss will help cancel out a future gain.
During times of economic crisis and fluctuating interest rates, investors may choose to keep money in short-term bonds that offer a faster return on investment, but at a lower yield. When the economy stabilizes, they may swap out their short-term bonds with long-term bonds, because long-term bonds offer higher rates of return. They may also switch out bonds that have almost reached their maturity date in order to lock in a higher interest rate.
Rating agencies rate a bond based upon the stability of the company or government issuing the bond. An investor may choose to swap out a bond that has a low credit rating with a bond that has a high credit rating in order to reduce risk. More aggressive investors may swap out highly rated bonds to speculate on lower rated bonds of underperforming companies in order to improve their return. Alternatively, investors who anticipate a decline in a certain sector of the economy may swap out their bonds and invest the proceeds in a different sector.
Most bond agreements allow the issuer to recall them after a certain time period before the maturity date, if the issuer pays back the full price of the bond. If a company or government redeems their bonds early, an investor who owns a bond that carries a high rate of return may have to reinvest his proceeds in an unfavorable market. To avoid this risk, an investor can swap current bonds for bonds that have a later call date.
About the Author
Alexander Newman has been a freelance writer since 2005, specializing in mental health issues, technical writing and literary journalism. He contributes to various websites and holds a Bachelor of Arts in biology from Virginia Tech.