Why Bond Prices Go Up and Down
Step 4: If Rates Go Up, Should I Sell My Bonds and Buy New Ones?
I own bonds issued years ago, when coupon rates were 4%. Rates are now much higher. Can't I sell my old bonds and buy new ones with higher coupons in order to earn more income?
The swap by itself will not result in higher yields: If you buy a bond that is comparable in maturity length and credit quality, the transaction will be a wash, because you would have to sell at that price at which the buyer of your old bonds would be indifferent to buying your bond or one carrying a higher coupon, meaning at the exact price which would result in the prevailing yield. You would receive less from your old bond than the price of a new bond and, therefore, your income from the bonds would not change.
For example, let us assume you own 10 bonds with a par value of $10,000 and a coupon rate of 4%. That means that annually you receive interest (coupon) income of $400. Assume further that over a period of several years, interest rates have risen to 8%. You sell your bonds for approximately $500 per bond, for a total of $5,000, which you now reinvest. You now own $5,000 (par value) bonds, and you will now receive annual interest of 8%; that is, $400. Therefore, even though you are now earning a coupon rate of 8%, you will be earning the same dollar amount as before the swap. Moreover, you would be out the transaction costs (commissions) incurred in selling the old bonds and buying the new bonds.
This does not mean that you should never consider swaps. There are other valid reasons for swapping. On the preceding transaction, you would generate a capital loss of approximately $5,000 and that might be used for tax purposes to offset capital gains on other transactions. Or you might swap to upgrade credit quality. You might increase yield by buying lower-quality bonds, or by buying different bonds.
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