An Old Favorite in a New Year: Bond Swaps!

The new year brings a spirit of rebirth and opportunities to improve upon what was less than ideal in the past year.  So amidst the football & frivolity, the laughs & the libations, let’s raise a glass to this new year for its most abundant blessing…another opportunity to get it right. 

Golfers have their Mulligans, cats have their Nine Lives, referees have their Instant Replay Booth and fixed income portfolio managers have their Bond Swaps.  After a year with seven consecutive Fed rate hikes which lifted the Fed Funds Target 425bps, there’s no shortage of swapping opportunities.

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).  Most likely, 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 reaped had the original bonds not been sold.  Bottom line: net income acquired will be greater than cashflows sold + loss on sale. 

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

When interest rates rise a “tax loss swap” is most common.  This is when a bondholder sells a bond at a loss and uses that loss to offset capital gains and/or future income.  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” (which is 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.  Please call your CCB Capital Markets rep for further discussion and a precise swap analysis.  We’re eager to assist!