What it means
Investors often review their bond holdings and look for a better return. A bond swap sells a bond now held and buys a different one, and the gain in annual yield is the yield pickup.
If the old bond yields 4.80% and the new one yields 5.40%, the pickup is 0.60 percentage points, or 60 basis points. The word pickup suggests a free gain, but extra yield is usually compensation for extra risk.
The new bond might have a lower credit rating, a longer maturity, a call feature that lets the issuer repay early, or less liquidity. A sensible swap compares the pickup with the added risk to see whether the payment is fair.
There are also practical costs. Dealers charge a spread when buying and selling, taxes may arise on a sold bond that has gained in value, and the investor may have to reinvest at a lower rate.
These costs reduce the net benefit, and a small pickup can be wiped out entirely. Treasurers and fund managers use the idea in many ways.
A cash manager may move surplus funds to a slightly longer maturity to pick up yield, while an insurer might replace a government bond with a corporate bond of similar life. The decision is usually tested against investment policy limits on credit quality, maturity and concentration.
A useful rule is to compute the breakeven, which is how long the extra income takes to cover the costs of the swap. If the costs equal one year of extra income, the swap pays for itself only after a year, and the investor is exposed to the new bond's risks during that time.
Short holding periods rarely justify a swap with high transaction costs. Market conditions also matter.
A pickup that looks attractive when the yield curve is steep may shrink quickly if rates move, and the bond bought may fall in price more than the one sold. Many investors therefore test the swap against a few interest rate scenarios before committing.
In practice
Real-world examples.
Example
A company treasurer reviews a portfolio of short-term government bonds and finds that high-quality corporate bonds of similar maturity pay 0.40 percentage points more. She moves $5,000,000 into corporate bonds within the limits of the investment policy. The company earns an extra $20,000 a year, and the treasurer records the reason for the change in the investment file. The audit committee later reviews the file to confirm that policy limits were respected.
Example
A pension fund manager swaps a government bond for a similar corporate bond to improve income. Before doing so, the credit team checks the issuer's finances and sets a maximum holding. The fund accepts a small amount of extra credit risk in return for the higher income.
Example
A private investor notices that a longer-maturity bond pays 0.30 percentage points more than his current holding. He realises that the longer bond will lose more value if rates rise and decides the extra yield does not justify the risk. He keeps his original bond and writes down the reasoning, so he can review it if the market changes. The exercise teaches him to ask what risk a higher yield is paying for.
Formula
Calculation
Yield pickup = yield on new bond - yield on old bond
Extra annual income = amount invested x yield pickup
Suppose a treasurer holds $2,000,000 in a bond yielding 4.80% and switches to another bond yielding 5.40%. Yield pickup = 5.40 - 4.80 = 0.60 percentage points. Extra annual income = 2,000,000 x 0.006 = $12,000. If the dealer spread and fees on the swap cost $6,000, the breakeven period = 6,000 / 12,000 = 0.5 years, or six months.Case study
Seen in the real world.
Elmstead Insurance is an illustrative, fictional insurer that holds $200,000,000 of fixed income investments to back its policies. The investment committee looked for ways to improve income without breaching its risk limits.
The team identified a group of bonds that could be replaced with bonds of the same rating and a similar maturity, but with a yield 0.25 percentage points higher. On $50,000,000, the pickup was worth about 50,000,000 x 0.0025 = $125,000 a year.
Before making the switch, the committee confirmed that transaction costs and tax effects were small compared with the gain, and that the replacement bonds had no early redemption features that could reduce income. The illustrative lesson is that a pickup is only real if the risk, cost and tax comparison also stacks up.
Watch out
Common mistakes.
- Treating yield pickup as a free gain, when it usually reflects extra credit, maturity or liquidity risk.
- Ignoring transaction costs and taxes, which can cancel out a small pickup.
- Comparing yields calculated on different bases, such as yield to maturity against yield to call, without adjusting them.
Questions
People also ask.
What is yield pickup?
It is the extra yield earned by switching from one bond to another with a higher yield.
Is a larger pickup always better?
No, because a larger pickup usually signals more risk, and the extra income may not compensate for it.
How do I know whether a swap is worthwhile?
Compare the extra annual income with the cost of the swap and the added risk, and calculate how long it takes to break even.
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