DEFINITION of 'Substitution Swap'

An exchange that is carried out by trading a fixed-income security for a higher yielding bond with similar features. A substitution swap involves the swapping of one bond for another bond that has a higher yield, but has a similar coupon rate, maturity date, call feature, credit quality, etc. A substitution swap allows the investor (such as a firm) to increase returns without altering the terms or risk level of the security. Investors will participate in substitution swaps when they believe there is a temporary discrepancy in bond prices due to market disequilibrium.

BREAKING DOWN 'Substitution Swap'

A swap is the exchange of one security for another to change some feature of the security, or because investment objectives have changed. For example, an investor may engage in a swap to change the maturity or quality of a security. There are multiple types of swaps including currency swaps, commodity swaps and interest rate swaps.

Substitution swaps are exchanges for higher yielding bonds. Since all other factors remain the same (i.e., maturity and credit quality), investors typically perform substitution swaps to take advantage of a promised higher yield. For example, a substitution swap might occur between two bonds that are each 20-year AAA bonds, but one has a 4% semi-annual yield while the other has a 4.5% semi-annual yield. The swap will replace the lower yielding bond with the higher yielding one. Market forces may bring the two yields together in the future if the bonds are perfect substitutes.

Swaps are not exchange-traded instruments; rather, they are traded on the over-the-counter (OTC) market between private parties. Because swaps occur on the OTC market, there is an inherent risk of a counterparty default. The swap markets consist primarily of activity from firms and institutional investors rather than individual investors.

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