A Sign of the Season: Bond Swaps!

It’s that time of the year...The mercury is dropping, spirits are rising and thoughts turn to blessings and baubles.  And after an historic year of bad price action, your bond portfolio can actually help make the season bright.  The age-old tradition of bond swapping might be your perfect fit this season.

In a bond swap, one or more bonds are sold with the proceeds being used to purchase other bonds with similar, but not identical, characteristics (such as maturity, credit quality, interest rate, yield or price).  Considering that bond yields have been (mostly) rising since summer 2020, the bonds sold will trigger a loss which will be fully recouped by new, additional income in excess of the income stream the investor would have earned had the original bonds not been sold.  Bottom line: net cash flows sold + loss on sale will be less than net income acquired.

Portfolio managers executing bond swaps are motivated by various rationales. Swapping bonds to increase yield (income) is the most common goal.  However, several other factors can also be the foundation of a swapping strategy, including (but not limited to):

• Extension swaps
• Quality swaps
• Call-protection swaps
• Tax-mitigation swaps

There are a few rules to be aware of when utilizing a tax-loss swap.  One vital consideration is making sure to avoid the “Wash Sale Rule.”  The IRS will not allow a loss generated from a wash sale; i.e., the sale and repurchase (within 30 days before or after the trade or settlement date) of either the exact same or substantially identical security.  Avoiding a wash sale in a bond swap completed within 30 days requires investors to buy a security that is not substantially identical to the security being sold.  Bonds with different issuers, maturity dates, prices or coupons should meet this test.  But, since “substantially identical” is not clearly defined by the IRS, be sure to check in with your CPA/tax advisor.

Your own interest rate outlook may be the most compelling motivation for which bonds to swap out of and into.  There are a handful of simple metrics to survey when determining the merit of one swap vs. another.  A common evaluation method is the net income comparison.  Under this approach the investor would compare the net income stream of the new bonds (proposed purchase) versus the net income stream of the old bonds (proposed sale).  If net benefit to the shortest average maturity comparison date is positive, the swap is profitable. 

 An example of such is shown below.  It illustrates realizing a loss to sell US Treasury Notes currently held to yield 1% and buying a US Agency (FHLB) bond of a similar maturity to yield 4.67%.  The swap is nearly $80k profitable on an after tax basis.

Please call your CCB Capital Markets rep for further discussion and a precise swap analysis.  We’re eager to assist!