Swapping As A Solid Bond Trading Strategy For Experienced Traders.

Any trader should know that forecasts made on purchasing day have to be adjusted tomorrow in light of changing circumstances and new discoveries. Keeping up with those changes, or better yet, anticipating them, is what any bond trading strategy is all about.

As a trader, the first considerations in bond selection are, of course, price and yield. Price is what you pay, yield is what you earn based on a bond's interest rate (coupon), current price and remaining years to maturity. For example: a bond selling 'at par' for $1000 with a coupon of 5% pays interest of $50 per year. Excluding issues of tax or inflation, the current yield is $50/$1000 = .05 = 5%.

Now, suppose interest rates have risen to 7% since the bond was first sold on the secondary market. The price of that bond will fall ('sell at a discount'), to say 98. (Bond prices are quoted as a percentage of the face value. 102 is 2% above par, 98 is 2% below par.) So, $1000 x .98 = 980. 50/980 = 0.51 = 5.1%.

Such calculations (and those more complicated, made easier by use of one of the many Internet available calculators designed for just that) are essential to forming a bond trading strategy.

Next we assume that the calculations are done and you've looked around the rest of the market and now believe you can get a better deal elsewhere. The next logical step to take is to either sell outright or execute a swap. A swap is a common bond trading strategy that involves selling one bond, then immediately buying another with the funds. (The investor never sees the details of the exchange.)

Bond traders do ‘swapping' for a multitude of reasons, let us try to explain why. Firstly, based on calculations, investors form projections. Those projections involve estimates of interest rate changes, changes in personal tax circumstances or general tax rates and laws, alterations in investment objectives or tolerance for risk and so on. Changing interest rates may make a 5% bond no longer attractive to hold. Rising rates yield higher payments from another. Fallen rates cause the sale price to increase giving an opportunity for capital gains.

Companies' fortunes wax and wane and the credit risk associated with a particular issue change accordingly. A bond rated A (borderline investment grade) can dip to B or worse. That risk level may be unacceptable to one investor but fine with another. Individuals retire, get promotions and inheritances, get lucky in the stock market, etc. Those changing financial and personal circumstances bring with them changes in tolerance for risk. Someone with substantially more capital may be more willing to speculate on a borderline high-yield bond. Retirees may want to lock in predictable interest payments from one more secure. Basically swaps are one way to manage changing circumstances and predictions.

Swapping is a bond trading strategy that can be carried out without realizing immediate capital gains. This is great because there will be zero tax liability. And if you're someone in a 33% tax bracket, that's very attractive.

Bond Trading Strategy