What Is a Substitution Swap?

A substitution swap is an exchange of a bond for another bond with similar characteristics (coupon rate, maturity date, 澳洲幸运5官方开奖结果体彩网:call feature, credit quality, etc.) that offers a higher yield.

Understanding Substitution Swaps

Essentially, a substitution swap allows the investor to increase returns without altering the terms or risk level of the security. A substitution swap can be a trade where one 澳洲幸运5官方开奖结果体彩网:fixed-income security is sold in order for the higher-yielding security to be bought. Investors participate in substitution swaps when they believe there is a temporary discrepancy in bond prices, or 澳洲幸运5官方开奖结果体彩网:yields to maturity (YTM), that will soon be co🙈rrected by m❀arket forces.

A swap is the exchange of one security for another to change some feature of the investment. The swap may also happen when investment objectives change. For example, an investor may engage in exchange to improve the 澳洲幸运5官方开奖结果体彩网:maturity date or the 澳洲幸运5官方开奖结果体彩网:credit quality of the security. Substitution swaps are often undertaken to avoid 澳洲幸运5官方开奖结果体彩网:capital gains taxes that would occur in an outright sale. There are many types of exchanges including 澳洲幸运5官方开奖结果体彩网:currency swaps, commodity swaps, and 澳洲幸运5官方开奖结果体彩网:interest rate swaps.

Substitution Swap Example

A substitution swap might occur between two bonds that are each 20-year AAA-rated corporate bonds with a 10% coupon, but one costs $1,000, and another is temporarily at a discount at $950. Over a year, both bonds yield $100 in ෴interest, but the holder of the first bond has gained 10% per dollar invested while the holder of the second bond has gained 10.5% per dollar invested since they paid $50 less for their bond.

As the example shows, the imbalance in the yield of two otherwise identical bonds is often quite small, perhaps a few 澳洲幸运5官方开奖结果体彩网:basis points. However, by reinvesting the extra return over the period that the two bonds differ, the gain can add up to a full percentage point or more. This strategy is called 澳洲幸运5官方开奖结果体彩网:realized compound yield and is what makes substitution swaps attractive. After a period of time called the 澳洲幸运5官方开奖结果体彩网:workout period, market force🔯s will bring the two returns together, so substitution swaps are usually considered short-term market plays—generally a year or less.

Substitution Swap Risks

Substitution swaps are not traded on an exchange but through the 澳洲幸运5官方开奖结果体彩网:over-the-counter (OTC) market between private parties. As such, there is a risk of counterparty default or the misrepresentation of bond qualities. Moreover, the strategy involves some element of market prediction, which is inherently risky. Because of these factors, the complexity of the process, and the need to invest large sums to realize meaningful gains over incremental yield shifts, substitution swaps are primarily undertaken by specialty firms and institutions rather than individual investors.