I am a long time investor in an active Australian Bond fund (set & forget type of thing) but lately I have been doing a lot of research and I have realised that bond managers use a lot of derivatives to manage risk and I'd really love to get a better understanding of it all.

Can someone please tell me how/why a manager would use interest rate swaps within a portfolio? I understand that these types of swaps basically swap a fixed rate for a floating rate, but how would it would within a bond portfolio sense?

I understand that a floating rate bond would have lower duration, so swapping out a fixed bond payment for a floating bond would mean would reduce the duration of the portfolio - is that correct? Do/can interest rate swaps do anything else to reduce interest rate exposure?

And finally does interest rate swaps do anything for the credit duration/credit risk of a portfolio?

Many thanks


You mention two of the main reasons to include interest rate swaps: to manage duration and manage interest rate risk. If a portfolio has bonds with both fixed and floating coupons, swaps can be used to reduce the interest rate risk associated with the floating coupons, or to exchange exposure in one tenor to another to manage exposure to the yield curve.

Currency Swaps can also be used to manage currency risk if the portfolio has bonds in multiple currencies (e.g. an international bond fund).

does interest rate swaps do anything for the credit duration/credit risk of a portfolio?

Note the same credit risk as, say, corporate bonds, but since interest rate swaps are not traded on an exchange, they are subject to counterparty risk. If the counterparty you're trading with goes bankrupt, and there is no collateral posted, the swap could die (although since a swap is an exchange of cash flows, the risk is small relative to the size of the swap).

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