Bond Swap: What it is, How it Works, Types

What Is a Bond Swap?

A bond swap consists of selling one debt instrument and using the proceeds to buy another debt instrument. Investors engage in bond swapping with the goal of improving their financial positions within a fixed-income portfolio.

For example, bond swapping can reduce an investor's tax liability, give an investor a higher yield, change a portfolio's duration, or help an investor to diversify their portfolio to reduce risk.

How a Bond Swap Works

When an investor engages in a bond swap, they are simply replacing a bond in their portfolio with another bond using the sale proceeds from the longer-held bond. There are a number of reasons an investor will swap bonds, one of which is to realize tax benefits. To do this, a bondholder will swap bonds close to year-end by taking a loss on the sale of a depreciated bond and using that loss to offset capital gains on their tax returns. This bond swap strategy is referred to as a tax swap.

An investor can lower their tax liability by writing off the losses on the bond they sold, as long as they do not buy a nearly identical bond either 30 days before or after the transaction. This is known as the wash-sale rule. Generally, a wash sale can be avoided by ensuring that two of the following three characteristics of the bond are different: issuer, coupon and maturity.

Special Considerations

An investor may also swap bonds to take advantage of changing market conditions. There is an inverse relationship between interest rates and the price of bonds. If interest rates in the markets decline, the value of the bond held by the investor will increase and maybe traded at a premium. The bondholder can capture a capital gain by selling this bond for a premium and rolling the proceeds into another suitable issue with a similar yield that is priced closer to par.

If prevailing interest rates in the economy are rising, the value of an investor's bond will be moving in the opposite direction. To take advantage of the higher rates, an investor could sell their lower coupon paying bonds and simultaneously purchase a bond with a coupon rate that matches the higher interest rates in the markets. In this case, the bond held in the portfolio may be sold at a loss since its value may be lower than the original purchase price, but the investor can potentially earn a better return with the newly purchased bond. In addition, a bond with a higher interest payment increases the yield and the annual interest income of the investor.

If interest rates are expected to rise, an investor may swap their existing bond with one with a shorter-term maturity since shorter-term bonds are less sensitive to changes in interest rates and should fluctuate less in value. This strategy is discussed in more details below.

Other Types of Bond Swaps

Change of Maturity Terms

Bond swaps are also done to shorten or extend maturities of a bond security. This type of bond swap is referred to as a maturity swap. In this case, an investor with a bond with one year left to maturity may swap it out with a bond that has five years left to mature. If interest rates are expected to decline, investors typically extend the duration or maturity of their holdings given that bonds with higher duration and longer maturities are more sensitive to changes in interest rates.

Therefore, longer-term bonds are expected to rise more than shorter-term bonds when interest rates fall. In addition, selling a shorter-term bond and purchasing a longer-term bond provides increased yield or income as the investor moves out along the yield curve. In a converse move, selling a longer-term bond and swapping it for a shorter-term maturity reduces price sensitivity if interest rates increase.

Swap Credit Quality

Swapping bonds to improve quality is when an investor sells one bond with a lower credit rating for a similar one with a higher credit rating. Swapping for quality becomes especially attractive for investors who are concerned about a potential downturn within a specific market sector or the economy at large, as it could negatively impact bond holdings with lower credit ratings.

Swapping to a higher-rated bond, for example, from a Baa to an Aa bond, may be a relatively easy way to gain greater confidence that the bond investors will have a higher probability of being repaid, in exchange for a lower yield.