Substitution Swap: Meaning, Example, Risks

What Is a Substitution Swap?

A substitution swap is an exchange of a bond for another bond with similar characteristics (coupon rate, maturity date, 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 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 yields to maturity (YTM), that will soon be corrected by market 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 maturity date or the credit quality of the security. Substitution swaps are often undertaken to avoid capital gains taxes that would occur 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 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 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 realized compound yield and is what makes substitution swaps attractive. After a period of time called the workout period, market forces 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 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.