What is yield pickup?
The increased interest rate that an investor earns by purchasing a higher-yielding bond and selling a lower-yielding bond is referred to as yield pickup. The goal of yield pickup is to raise a portfolio’s risk-adjusted performance.
Understanding a Yield Pickup Strategy
A yield pickup is an investing technique where bonds with lower yields are exchanged for bonds with more significant results. Increasing work increases profits, but this method has a higher risk. Generally speaking, a bond with a greater yield will have a longer maturity than one with a lower result. Bonds with longer maturities are more susceptible to changes in market interest rates. Therefore, an investor is exposed to interest rate risk with a longer-term bond.
Furthermore, there is a positive correlation between risk and yield. Investors need more extensive work to be enticed to buy the bond; the higher the product, the higher the perceived risk of the bond. Compared to bonds with lesser risk, those with greater risk have inferior credit quality. As a result, there is some risk associated with a yield pickup since higher-yielding bonds sometimes have worse credit quality.
For instance, a bond with a 4% yield that an investor owns Company ABC issued. The bond, which Company XYZ issued with a 6% yield, is available for sale by the investor. The yield gain for the investor is 2% (6% minus 4% = 2%). A greater yield to maturity (YTM), a larger coupon, or both might benefit from this approach. A yield pickup strategy is riskier since bonds with a greater default risk often offer higher yields. Bonds with the same grade or credit risk should ideally be included in a yield increase, but this is only sometimes true.
Obtain and Exchange
The pure yield pickup swap, the foundation of the yield pickup strategy, takes advantage of bonds that have been momentarily mispriced. It does this by selling overpriced bonds in the portfolio and purchasing underpriced bonds that are the same types as those held in the portfolio, which pay a lower yield. By exchanging lower-coupon bonds for higher-coupon bonds, the investor bears a greater risk of reinvestment when interest rates drop since there is a chance that the issuer may “call” the high-coupon bond. An additional danger exists if interest rates rise. For example, the investor can lose money if interest rates rise during the transaction or throughout the bond’s holding period in the economy.
The only purpose of using the yield pickup approach is to increase yields. There is an optional need to forecast or speculate on how interest rates will move. If this method is used correctly and at the appropriate moment, it yields considerable profits.
Investopedia does not provide financial advice or services related to taxes or investments. Investors in assets are not taken into account while presenting the facts. Investing has risk, which includes the potential for principal loss.
