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“A look at the concept of a bond swap now bond swaps occur when one one den instrument is sold and the proceeds are used to purchase another dead instrument is you re swapping. One bond for another bond. Hence. The name bond.
Swaps and bond swaps. Can be used for a number of reasons. They can be used to increase current yield or yield to maturity. They can be used to take advantage of shifts and interest rates.
You might also engage in a bond swap to improve the quality of the portfolio and you might also use it for tax purposes. Now in a yield pickup swap. An investor switches out a low coupon bond into a comparable higher coupon tissue okay this can increase current yield or yield to maturity so for example you sell a 20 year a rated six and a half percent bond yielding. 8.
At the time and replaced them..
With an equal amount of 20 year a rated 7 bonds price to yield. Eight and a half percent. So we can see here that your current income increases from sixty five dollars a year to seventy dollars a year and your yield to maturity increases from eight percent to eight and a half percent. So if you see an opportunity in the market to do this this may be a good strategy to pursue another thing that can be done is what s known as a great anticipation swap investors exchange mods according to their duration and expected interest rate movement.
So for example if an investor expects interest rates to fall. She s going to sell bonds with a lower duration and purchase bonds with a higher duration. Why because we know that when interest rates. Fall bond prices go up and they go up more for higher duration bonds.
Likewise. If if she expected interest rates to run. She would swap out for higher duration bonds for lower duration bonds. So.
When prices fell..
They wouldn t fall. Quite as much you can engage in what s known as a quality swamp investor. Here s looking to move from a bond. With a lower quality rating to a bond with a higher quality rating or vice versa.
Now the spread between the yields of bonds with different credit quality generally narrows. When the economy is improving and widens when the economy weakens. So. If you think about it.
This is the case where you know during times that are really good okay good economic times. You might as well purchase the lower rated bonds lower quality bonds because the chance of the company defaulting on the bonds is much much less likely to happen so you purchase those bonds that have a little higher yield now of course. If you think there s a recession coming you d want to get rid of those lower quality bonds and exchange them for higher rated bonds because what s likely to happen. The price of those lower rated bonds is going to fall.
As people flee those risky bonds for fear that this recession may cause some of these less highly rated companies less financially sound companies to default on their bonds..
Okay. The last thing to mention is what s known as a tax swap in this case. You sell bonds for a loss. And you replace them with similar.
But not identical bonds and this is the case. Where you may have a gain on some asset your stock portfolio. And what you want to do is you want to sell something at a loss. So that you can offset those gains with losses.
Now you have to be careful if you engage in one of these bond swaps. Because the internal revenue service. Will not recognize a tax loss generated from the sale and repurchase within 30 days before after the trade or settlement. Date of the same or substantially.
What s known as a wash sale that is you can t sell your 20 year. Ivm bonds at a loss and then turn around and buy those back. However you can sell those 20 year. Ivm bonds and purchase something a bond that s similar and generally you know this term similar is hard to hard to gauge hard to know exactly what the irs will will determine to similar and making a wash sale.
But generally if you purchase the bonds from another company. So if you sold ibm s bonds. And you purchased you know microsoft s bonds if they had bonds you know that might be close enough you know to keep your portfolio similar in terms of its risk. But it might also be sufficient that the irs does not ” .
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