Bond Swap

What Is a Bond Swap?

A bond swap comprises of selling one debt instrument and utilizing the proceeds to buy another debt instrument. Investors participate in bond swapping determined to advance their financial situations inside a fixed-income portfolio.

For instance, bond swapping can reduce an investor's tax liability, give an investor a higher yield, change a portfolio's duration, or assist an investor with differentiating their portfolio to reduce risk.

How a Bond Swap Works

At the point when an investor takes part in a bond swap, they are just supplanting a bond in their portfolio with another bond utilizing the sale proceeds from the longer-held bond. There are a number of reasons an investor will swap bonds, one of which is to acknowledge tax benefits. To do this, a bondholder will swap bonds close to year-end by writing off the sale of a depreciated bond and utilizing that loss to offset capital gains on their tax returns. This bond swap strategy is alluded to as a tax swap.

An investor can bring down their tax liability by discounting the losses on the bond they sold, as long as they don't buy an anywhere close to indistinguishable bond either 30 days before or after the transaction. This is known as the wash-sale rule. Generally, a wash sale can be abstained from by guaranteeing that two of the accompanying three qualities of the bond are unique: issuer, coupon and maturity.

Special Considerations

An investor may likewise swap bonds to exploit changing market conditions. There is an inverse relationship between interest rates and the price of bonds. On the off chance that interest rates in the markets decline, the value of the bond held by the investor will increase and perhaps traded at a premium. The bondholder can capture a capital gain by selling this bond for a premium and rolling the proceeds into one more suitable issue with a comparative yield that is priced closer to par.

On the off chance that overarching interest rates in the economy are rising, the value of an investor's bond will be moving the other way. To exploit the higher rates, an investor could sell their lower coupon paying bonds and at the same time 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 might be sold at a loss since its value might be lower than the original purchase price, yet the investor might possibly earn a better return with the recently purchased bond. Likewise, a bond with a higher interest payment increases the yield and the annual interest income of the investor.

In the event that interest rates are expected to rise, an investor might swap their existing bond with one with a more limited term maturity since more limited term bonds are less sensitive to changes in interest rates and ought to vacillate less in value. This strategy is talked about in additional subtleties below.

Different Types of Bond Swaps

Change of Maturity Terms

Bond swaps are likewise finished to abbreviate or extend maturities of a bond security. This type of bond swap is alluded to as a maturity swap. In this case, an investor with a bond with one year left to maturity might swap it out with a bond that has five years left to mature. Assuming interest rates are expected to decline, investors normally 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.

In this way, longer-term bonds are expected to rise more than more limited term bonds when interest rates fall. Likewise, selling a more limited term bond and purchasing a longer-term bond gives increased yield or income as the investor moves out along the yield curve. In an opposite move, selling a longer-term bond and swapping it for a more limited term maturity reduces price sensitivity on the off chance that interest rates increase.

Swap Credit Quality

Swapping bonds to further develop quality is the point at which an investor sells one bond with a lower credit rating for a comparable one with a higher credit rating. Swapping for quality turns out to be especially appealing for investors who are worried about a possible downturn inside 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 instance, from a Baa to an Aa bond, might be a generally simple method for gaining greater confidence that the bond investors will have a higher likelihood of being reimbursed, in exchange for a lower yield.

Features

• Bond swaps could likewise be utilized to abbreviate or extend maturities or duration of a bond or further develop the credit quality of a fixed-income portfolio.
• Investors must be careful to keep away from wash sales during these types of transactions.
• A bond swap happens when the proceeds from the sale of one debt instrument are utilized to in this manner purchase another debt instrument.
• Bond swaps can be utilized to accomplish tax benefits, known as a tax swap; or probably be utilized to exploit changing market conditions.