The mechanics of a bond swap involve opportunity cost versus potential reward. There are various reasons to enter into a bond swap, but the evaluation process for all of them remains the same. Analysis of the merits of bond swapping must compare the expected return from the new bond being swapped into; versus the return being forgone from the old bond that is being swapped out of.
In addition, the transaction cost must be evaluated and factored in; so that the expected return from the new bond still outperforms that from the old bond, after all transaction costs have been deducted.
Transaction cost must not simply be looked at as the commission that the agent or broker for the transaction charges. Bonds are traded on a bid-offer spread. One sells on the bid side and buys on the offer side of the market. The investor must therefore understand that when a swap is executed, the bid-side of the market on the old bond is being “hit”; and the offer side of the new bond is being “lifted”. Bid-offer spreads depend on the nature of the underlying bonds; and the market conditions prevailing at the time of the transaction.
Features of bonds that determine bid-offer spread size include the following:
the credit quality of the company issuing the bond, the size of the bond issue, the face amount or denomination of the bond being traded, the number of dealers quoting and trading the bond, the secondary market liquidity in the bond issues being traded, the underlying level of interest rates at the time, the medium of exchange that the bonds are being traded on; and the general market conditions at the time of the transaction.
Bonds with low credit quality generally have wider bid-offer spreads than those of a higher credit rating. A large bond issue can be expected to have a narrower bid-offer spread, because there is greater liquidity in the issue. Large bond issues however, may not have great liquidity; if they have been bought in large quantities by a small number of investors. Bonds that have been well distributed, across a larger universe of investors, therefore tend to have more liquidity and narrower bid-offer spreads. If the bonds being swapped are in a small transaction size, as is often the case with small investors, then the bid-offer spread quoted by the dealer will be wider. The greater the number of dealers and market makers in a specific bond issue, then the narrower will be the bid-offer spread.
Bonds are first issued in the primary market, after which they move to the secondary market. Dealers and market makers may also hold an inventory of bonds. Large primary issues can be expected to have narrow bid-offer spreads. After the “Credit Crisis”, regulators forced banks to carry more balance sheet capital to offset potential losses on securities. Dealers and market makers therefore carry smaller inventory today, which reduces the liquidity in the market place; and makes bid-offer spreads wider.
When the prevailing level of interest rates is high, the financing of dealer inventories is costly. Dealers and market makers therefore carry smaller inventory, and bid-offer spreads are wider to reflect this. When interest rates are low, inventory financing costs are lower, and dealers will carry higher levels of inventory and quote narrower bid-offer spreads.
Transaction costs are lower on electronic exchanges than over-the-counter, or on physical exchanges. Finally, in times of uncertainty regarding interest rates, bid-offer spreads will be wider.
The bid-offer spreads being quoted to an investor, when a swap transaction is being priced, are therefore a combination of all the above listed factors. An investor should consider first, how the bid-offer spread that is being quoted has been influenced by all of these factors. This consideration may lead to the conclusion that the timing of the swap has no merit.
In addition to the transaction cost, the bond investor must also look at the return that is being forgone in the old bond. This can be looked at as the holding period return from earning the coupon, plus the expected capital gain, over the period that the investment is contemplated. The transaction cost plus the return forgone must then be compared with the expected holding period return of the new bond.
A bond swap will only have merit if the new bond holding period return. After all, transaction costs are greater than those from the old bond. The bond investor must also understand that when the new bond is sold, a new bid-offer spread must be subtracted from the return. This exit bid-offer spread must be subtracted from the expected return from holding the new bond. Clearly, if the investor expects to hold the new bond to maturity, this will not be the case.
There may be specific circumstances when a bond swap has merit; that compensates for the opportunity cost of the forgone return and the transaction cost. These circumstances will now be identified.
Credit decisions can be company specific or macroeconomic. An investor may perceive that the credit of the company issuing the bond he owns is going to weaken, so he will have a potential capital loss on his investment. He therefore has an incentive to swap out of the bond he owns, into a bond of a company with similar rating but better prospects. The capital loss remaining in the old bond must therefore be added to the potential gain from holding the new bond. Conversely, the investor may swap into a bond that is about to be upgraded because of a company specific event. The capital gain from the upgrade must then be included in the holding period return from the new bond.
Macroeconomic conditions can change the value of a bond. A slowing economy, that weakens the revenue potential of companies; can be seen as an event that impacts companies with weaker balance sheets more than ones with strong balance sheets. It is therefore optimal to swap into higher rated bonds when an economic slowdown is anticipated. Conversely, when the economy is doing well, there is an incentive to earn the extra income associated with bonds that have a lower credit rating.
The level of interest rates and central bank monetary policy must be evaluated when contemplating bond swaps. If interest rates are expected to fall, bonds with low coupons and long maturities can be expected to outperform and vice versa. Interest rate expectations and the capital gain associated with changes in interest rates can thus drive the economics of a bond swap. The capital gain or loss, associated with a move in interest rates, must be calculated and factored into the return analysis that is driving the swap.
Under specific circumstances, the opportunity for arbitrage may drive a bond swap transaction. An arbitrage in a bond swap involves the swap exploiting a mispricing between securities. The two bonds are similar in all respects except price. If the mispricing is large enough, then it may be possible to swap the bonds and achieve a pickup in interest income that compensates for the transaction costs. It should be noted that if the investor is considering reversing the swap, to realize the value of the arbitrage, that the bid-offer spread from unwinding the swap must also be subtracted from the returns.
In conclusion, it can be said that there are various different scenarios under which bond swapping has merit. The same investment process of analyzing the opportunity and transaction costs associated with each kind of swap must be evaluated against the potential economic return. This quantifies its merit in financial terms.