Bond swap definition
An investment strategy when an investor sells one debt instrument and uses the funds from the sale to buy another debt instrument
Bond swap meaning
The bond swap technique is performed with debt instruments such as bonds. An investor sells a bond held in their portfolio in order to buy another bond with the money received from the sale.
Reasons for using bond swap
Numerous reasons can lead to the decision to use the bond swap technique. Some common reasons are: expectations about interest rates movements, maturity transformation, credit quality transformation, lowering taxes and plans to change an industry.
Bond prices are inversely related to movements in market interest rates. When market interest rates increase, bond prices decrease. This decrease occurs because the newly issued bonds will offer a higher yield to potential investors. Thus, investors who are expecting changes in market interest rates can use the bond swap technique to avoid a possible decrease in the value of bonds in their portfolio or buy a debt instrument with a higher coupon rate.
Bond swaps can also be used for maturity transformation. An investor can sell long-term debt instruments and use the proceedings to buy short-term ones. In such a case, the investor decreases the price sensitivity and limits the exposure to potential interest rate movements. The investors could also do the opposite transaction, where short-term bonds are swapped with long-term bonds. In this case, they can increase the yield from the debt instruments held in their portfolio.
Bond swaps for credit quality transformation are used by investors when they want to change the quality of the instruments in their portfolios. Through the bond swap, they can exchange low-quality bonds for high-quality bonds. Also, investors could decide to sell bonds with good credit quality and buy bonds with lower credit quality that offer a higher yield.
Bond swaps can also be used for lowering the taxes paid on capital gains or other income taxes. With bond swapping, investors are selling bonds at a lower price than the price they paid. The loss realised from the bonds should offset tax obligations for other forms of income and gains.
Bond swaps can enable investors to maintain a certain level of debt in their portfolio while changing the origin of the debt. Investors can sell bonds issued by companies from one industry and replace the debt by buying bonds issued by companies from another industry.