What is a Pure Yield Pickup Exchange?
A pure yield swap consists of exchanging a set of obligations on the other hand, the intention to increase the return received on these bonds. It is important to note that the term assumes that the increase in yield will not come at the expense of an increase in bond risk.
Typically, this swap will involve the sale of bonds at a relatively short deadlines and buying bonds with relatively long maturities, since bonds with longer maturities generally offer higher yields.
Key points to remember
- A pure yield swap is a strategy of selling short-dated bonds in exchange for longer-dated bonds.
- The goal of the strategy is to increase the total return of the bond portfolio.
- Investors using the pure yield swap strategy will seek to ensure that the new bonds they buy are of the same or better credit quality than the bonds they sold.
How Pure Yield Swaps Work
Generally speaking, bond investors who wish to increase the yield received on their bonds have two primary means of achieving this goal. Either they can swap their bonds for riskier but higher yielding alternatives, or they can lengthen the average maturity of their portfolio. By exchanging bonds with shorter maturities for bonds with relatively longer maturities, investors may be able to increase the yield of their portfolio without significantly increasing the risk of their holdings.
When considering implementing a pure yield swap, investors should ensure that the new bonds they buy have a similar risk profile to the bonds they sell. For example, if an investor sells five-year corporate bonds and is looking to buy 10-year corporate bonds, he must ensure that the issuer of the 10-year bonds is not more at risk of bankruptcy Where default as the issuer of the five-year bonds. A simple way to achieve this goal is to swap bonds issued by the same issuer, as if the same company issued the five- and 10-year bonds in the example above.
When evaluating a potential pure yield swap, investors will need to consider whether the additional yield received on longer-maturity bonds is sufficient to compensate them for the additional risks associated with a longer maturity period. These include interest rate risks, inflation risks, and the risk that the issuer may default on its debts. Reorienting their portfolio towards bonds with relatively long maturities could also reduce the investor’s liquidity, making them less able to react to any unforeseen future shocks.
Other types of swaps
Other approaches used by bond investors include forward-looking swaps, in which bonds are swapped based on their current duration and expected interest rate movements; substitution swaps, in which bonds with very similar characteristics are exchanged in such a way that the total level of risk is not affected; and intermarket spread swaps, where investors seek to exploit a yield difference between two bonds in different parts of the same market.
Example of a pure yield swap
Dorothy is a successful entrepreneur who recently received $2 million in cash for the sale of her business. To plan for her retirement, she invested all of the proceeds from the sale in corporate bonds issued by XYZ Company.
At the time of her purchase, XYZ bonds offered a yield of 3.75%, which was enough to provide Dorothy with a comfortable retirement income. Since then, however, Dorothy has decided to take a more active investment stance and is therefore looking for ways to further increase the yield of her bond portfolio. She decides to perform a pure yield swap, exchanging her XYZ bonds for a comparable but longer-dated instrument that will offer a higher yield.
To decide which new bond to buy, Dorothy starts by looking at companies with similar credit ratings to XYZ. To help her make her decision with more confidence, Dorothy limits her research to industries she knows personally, so she can better judge the accuracy of credit reports. It identifies three bonds, each issued by competitors within XYZ’s industry, that offer longer maturities than its existing XYZ bonds. If she swaps her XYZ bonds for these new securities, Dorothy estimates she can increase her total return to 4.50%.
Dorothy is confident that the issuers of the three new bonds have similar or better financial strength than XYZ, and therefore should not pose greater problems. credit risk. Moreover, it believes that the additional yield offered by these bonds is an adequate compensation for the increase in interest rates, inflation and Liquidity risk represented by their longer maturities. Based on this analysis, she decides to execute the pure yield swap, selling her XYZ bonds in exchange for the bonds of the three new issuers.