Substitution Swap


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.

  1. Coupon

    The annual interest rate paid on a bond, expressed as a percentage ...
  2. Swap

    A derivative contract through which two parties exchange financial ...
  3. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
  4. Callable Bond

    A bond that can be redeemed by the issuer prior to its maturity. ...
  5. Workout Period

    The period of time when temporary yield discrepancies between ...
  6. Yield

    The income return on an investment. This refers to the interest ...
Related Articles
  1. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  2. Options & Futures

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  3. Bonds & Fixed Income

    Asset Allocation In A Bond Portfolio

    An investor's fixed-income portfolio can easily beat the average bond fund. Learn how and why!
  4. Retirement

    Bond Basics Tutorial

    Investing in bonds - What are they, and do they belong in your portfolio?
  5. Bonds & Fixed Income

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  6. Financial Advisors

    Ditching High-Yield Bonds for Plain Vanilla Ones

    In a low-rate environment, it's tempting to go for higher yield bonds. However, you might be better off sticking with the plain vanilla ones.
  7. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  8. Bonds & Fixed Income

    What is an Indenture?

    An indenture is a legal and binding contract between a bond issuer and the bondholders.
  9. Bonds & Fixed Income

    Credit Default Swaps: An Introduction

    This derivative can help manage portfolio risk, but it isn't a simple vehicle.
  10. Investing

    Understanding High Yield Fund Performance

    For exchange traded fund, not all high-yield ETFs are the same. So, we take a look at one high yield investment in particular to set the stage for you.
  1. What are the maximum Social Security disability benefits?

    The average Social Security disability benefit amount for a recipient of Social Security Disability Insurance (SSDI) in 2 ... Read Full Answer >>
  2. Do penny stocks trade after hours?

    Penny stocks are common shares of public companies that trade at a low price per share. These companies are normally small, ... Read Full Answer >>
  3. How do I calculate the future value of an annuity?

    When planning for retirement, it is important to have a good idea of how much income you can rely on each year. There are ... Read Full Answer >>
  4. Have hedge funds eroded market opportunities?

    Hedge funds have not eroded market opportunities for longer-term investors. Many investors incorrectly assume they cannot ... Read Full Answer >>
  5. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  6. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  2. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  3. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  4. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  5. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the ...
Trading Center