Active Bond Investment Strategies: Techniques and Risks for Experienced Investors

Active Bond Investment Techniques

Instead of pursuing a passive bond investment strategy, some investors trade bonds to profit from changes in interest rates, yield differences, or perceived market mispricing. Such strategies are frequently pursued through bond swaps or the exchange of one bond for another or one bond type for another. In certain instances, investors exchange bonds for straightforward reasons. For instance, you may prefer the relative safety of a Treasury bond to that of a corporate bond, or you may desire the higher yield of a junk bond despite its higher risk. However, bond swaps can also increase yields or reduce capital gains taxes and interest-rate risk.

Caution: transaction costs associated with bond swaps can reduce any potential gains.

Changes in Pure Yield Pickup

A pure yield pickup swap is perhaps the most straightforward type of bond swap. The yield on longer-term bonds is typically more significant than that on shorter-term bonds. Why? Because the greater the risk, the longer a bondholder must wait for the principal to be repaid compared to an identical bond with a shorter maturity. Investors demand a higher return in exchange for this increased risk. This type of swap would involve selling short-term bonds and purchasing long-term bonds with a higher yield, thereby increasing your income. A yield pickup swap with no interest rate, yield curve, or credit rating speculations is considered pure.

Tax Swaps

You could engage in a tax swap to reduce your total capital gains and corresponding capital gains tax liability. With this strategy, you would sell at a loss bond whose value has decreased, possibly due to rising interest rates. The loss could be applied against the gains. To complete the swap, you would purchase new bonds of comparable quality and maturity with the proceeds from the sale.

Yield Spread Techniques

Yield spread refers to the difference between the yields of two bonds or bond types. Using the yield spread, some investors attempt to profit from changes in interest rates or bond market fluctuations.

To follow the yield curve

In some instances, increasing the return on short-term investments may be possible by systematically exploiting the yield spread between short- and long-term maturities.

The yield curve compares the yields of comparable securities with varying maturities. As maturities lengthen and yields increase, this line typically slopes upward. The steeper the yield curve, the greater the difference between the yields on 3-month T-bills and 30-year bonds. The yield curve can be flat or even inverted if short-term rates exceed those of longer maturities.

However, when the yield curve is upward-sloping and does not change significantly during the investment horizon, a strategy known as riding the yield curve may be employed. As the maturity date of long-term bonds approaches, their yields begin to approach those of shorter maturities; the yield on a 10-year bond that is only two years away from maturity may be comparable to that of a 2-year note. Simultaneously, however, its price would increase as bond prices rise when yields fall. In such a scenario, you may be able to sell the 10-year bond for a profit.

You have $10,000 that you would like to invest in a two-year income security. You could purchase a two-year Treasury note that matures when you need your principal back. Alternatively, you could purchase a brand-new 5-year Treasury note, hold it for two years, and sell it before maturity. Assuming that the yield on the 5-year note is more significant than that on the 2-year note, you could ride the yield curve by profiting from both the longer maturity's higher yield and the increase in the bond's value as its yield declines over time.

Caution: Only use this strategy if the yield curve slopes upward and is expected to remain stable if you hold the bond. The yield may exceed expectations if interest rates decline and bond prices rise. However, if interest rates increase and the yield curve flattens or inverts, the advantage of this strategy would diminish. You may not earn more than if you had purchased a bond with a shorter maturity, and you may even lose money or be forced to hold the bond for a longer period of time than you had planned to avoid a loss.

Caution: Remember that strategies involving selling one bond and purchasing another will incur transaction costs, which may reduce the potential financial gain.

Substitutional Changes

In a substitution swap, you sell a bond and replace it with another bond with identical characteristics (e.g., maturity, coupon rate, and credit rating) but a different yield, typically one with a higher yield that would increase your overall return. You might perform a substitution swap if you believe a bond is mispriced and has the potential for price appreciation, for instance, if you believe its credit rating is too low and may be raised.

A similar yield spread strategy, intermarket spread swap, occurs when an investor believes that one type of bond is temporarily mispriced compared to another. This swap would involve selling one type of security and purchasing another (e.g., exchanging a government bond for a corporate bond with a similar maturity and coupon rate) in the belief that their prices will fluctuate at different rates and that one may be more profitable than the other.

Assume that the yield spread between corporate bonds and Treasuries is more comprehensive than usual, which indicates that investors are less confident in the creditworthiness of corporate bonds in general and are demanding higher yields. Suppose you also believe the economy will soon begin expanding, thereby reducing the credit risk of corporations. You may decide to replace some of your Treasury holdings with corporate bonds to profit if corporate bond prices rise more quickly than Treasury bond prices. In contrast, if you believe the economy will slow and the yield spread between corporates and Treasuries will widen because investors will be drawn to the safety of Treasuries, you could exchange some corporate bonds for Treasuries to reduce the risk of price loss if the yield spread widens. Corporate bond prices fall more quickly than Treasury prices.

Swaps on Rate Anticipation

A rate anticipation swap requires a degree of speculation. However, success could allow you to take advantage of future rate changes (or avoid unfavorable consequences). If you anticipate an increase in interest rates, you could exchange your long-term bonds for shorter-term ones whose prices will not fluctuate as dramatically. This would reduce the duration of your portfolio. If you believe that interest rates will decline, you could increase the duration of your portfolio by exchanging short-term bonds for long-term bonds to lock in higher yields.

Caution: If you guess incorrectly, the impact of the rate change on your finances will be amplified by your swap.

The Lynch Retirement Investment Group has prepared some of the following materials. The material is considered reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. The investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with the appropriate professional.

Bond prices and yields are subject to change based on market conditions and availability. If bonds are sold before maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall, and when interest rates fall, bond prices generally rise. 

There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall, and when interest rates fall, bond prices generally rise.

Bonds are subject to risk factors, including: 

1) Default Risk - the risk that the issuer of the bond might default on its obligation

2) Rating Downgrade - the risk that a rating agency lowers a debt issuer's bond rating

3) Reinvestment Risk - the risk that a bond might mature when interest rates fall, forcing the investor to accept lower rates of interest (this includes the risk of early redemption when a company calls its bonds before maturity)

4) Interest Rate Risk - this is the risk that bond prices tend to fall as interest rates rise.

5) Liquidity Risk - the risk that a creditor may not be able to liquidate the bond before maturity.

Treasury Bills are certificates reflecting the U.S. government's short-term (under one year) obligations.

Remember that there is no assurance that any strategy will ultimately be successful or profitable or protect against a loss.

Before making an investment decision, please consult your financial advisor about your situation.

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Lynch Retirement Investment Group 2016, 2017, 2018, and 2019

John M. Lynch, CIMA®, CPWA®

John M. Lynch, CIMA®, CPWA® Managing Director – LRIG,
Financial Advisor– RJFS, of Lynch Retirement Investment Group, LLC.
Was named on the 2021 Forbes Best-In-State Wealth Advisor List.

John M. Lynch, CIMA®, CPWA® Managing Director – LRIG, Financial Advisor – RJFS

Andrew Fentress, CFP® Financial Advisor

Adam Tobin, CFP®, CRPC Customer Relationship Manager

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