Substitution Swap

What Is a Substitution Swap?

A substitution swap is an exchange of a bond for another bond with comparative attributes (coupon rate, maturity date, call feature, credit quality, and so on) that offers a higher yield.

Understanding Substitution Swaps

Basically, a substitution swap permits the investor to increase returns without modifying the terms or risk level of the security. A substitution swap can be a trade where one fixed-income security is sold for the higher-yielding security to be bought. Investors take part in substitution swaps when they accept there is a transitory disparity in bond prices, or yields to maturity (YTM), that will before long be remedied by market powers.

A swap is the exchange of one security for another to change some feature of the investment. The swap may likewise happen when investment objectives change. For instance, an investor might take part in exchange to further develop the maturity date or the credit quality of the security. Substitution swaps are frequently attempted to stay away from capital gains taxes that would happen in an outright sale. There are many types of exchanges including currency swaps, commodity swaps, and interest rate swaps.

Substitution Swap Example

A substitution swap could happen between two bonds that are every 20-year AAA-rated corporate bonds with a 10% coupon, however one costs $1,000, and another is briefly at a discount at $950. Over a year, the two bonds yield $100 in interest, yet the holder of the principal bond has gained 10% per dollar invested while the holder of the subsequent bond has gained 10.5% per dollar invested since they paid $50 less for their bond.

As the model shows, the imbalance in the yield of two otherwise indistinguishable bonds is in many cases very small, maybe a couple basis points. Notwithstanding, by reinvesting the extra return over the period that the two bonds vary, the gain can amount to a full percentage point or more. This strategy is called realized compound yield and makes substitution swaps appealing. After a period of time called the workout period, market powers will unite the two returns, so substitution swaps are normally viewed as short-term market plays — for the most part a year or less.

Substitution Swap Risks

Substitution swaps are not traded on an exchange but rather through the over-the-counter (OTC) market between private gatherings. In that capacity, there is a risk of counterparty default or the misrepresentation of bond characteristics. Moreover, the strategy includes some element of market prediction, which is innately risky. In light of these factors, the complexity of the cycle, and the need to invest large aggregates to acknowledge significant gains over incremental yield shifts, substitution swaps are fundamentally embraced by specialty firms and institutions rather than individual investors.

Features

• Substitution swaps are short-term plays whose draw lies in a strategy called realized compound yield.
• Substitution swaps are utilized by investors when they think there might be a brief error in bond prices that will before long be revised by market powers.
• A substitution swap is the exchange of one bond for another that has comparative qualities yet offers a higher yield.