What Is Yield Pickup?
Let me explain yield pickup directly to you: it's the extra interest rate you, as an investor, can gain by selling a bond with a lower yield and buying one with a higher yield. I use this approach to enhance the risk-adjusted performance of my portfolio, and you might consider it for yours too.
Understanding a Yield Pickup Strategy
You need to grasp that a yield pickup strategy means trading bonds with lower yields for those with higher yields. While this can lead to better returns, it also brings more risk. Typically, a lower-yield bond has a shorter maturity, whereas a higher-yield one has a longer maturity. Those longer-term bonds are more affected by interest rate changes in the market, so you're taking on interest rate risk with them.
There's also a direct link between yield and risk: higher perceived risk in a bond means investors demand a higher yield to buy it. Bonds with higher risk usually have lower credit quality compared to safer ones. So, when you go for a yield pickup, you're accepting some risk because the higher-yield bond often has lower credit quality.
For instance, suppose you own a bond from Company ABC yielding 4%. You could sell it and buy a bond from Company XYZ yielding 6%. That gives you a 2% yield pickup (6% minus 4%). This can come from a higher coupon, higher yield to maturity, or both. Bonds with greater default risk tend to offer higher yields, which makes this strategy risky. Ideally, you'd swap bonds with the same rating or credit risk, but that's not always possible.
Pickup and Swaps
The yield pickup strategy builds on the pure yield pickup swap, where you take advantage of temporarily mispriced bonds. You buy underpriced bonds that yield more than similar ones in your portfolio and sell the overpriced ones that yield less. This involves swapping lower-coupon bonds for higher-coupon ones, which raises your reinvestment risk if interest rates drop, as the issuer might call the high-coupon bond.
You also face risk if interest rates rise during the transaction or while holding the bond, potentially leading to a loss. I enter this strategy just to get higher yields; you don't have to speculate on interest rate movements. If you implement it correctly and at the right time, it can deliver solid gains.
Important Disclaimer
Remember, this isn't tax, investment, or financial advice from me or anyone. The details here don't consider your specific investment situation. Investing carries risks, including the potential loss of your principal.
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