What is a 'Substitution Swap'

A substitution swap is a bond exchange that trades fixed-income securities for higher-yielding security with a similar coupon rate, maturity date, call feature, credit quality, etc. A substitution swap allows the investor to increase returns without altering the terms or risk level of the security. 

Investors participate in substitution swaps when they believe there is a temporary discrepancy in bond prices or yields-to-maturity due to market disequilibrium.

BREAKING DOWN 'Substitution Swap'

A swap is the exchange of one security for another to change some feature of the invest. 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. Bond 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.

Example of a Substitution Swap

A substitution swap might occur between two bonds that are each 20-year AAA-rated corporate bonds with a 10 percent 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 percent per dollar invested while the holder of the second bond has gained 10.5 percent per dollar invested since they paid $50 less for their bond.

As the example shows, the imbalance in yield of two otherwise identical bonds is often quite small, perhaps a few basis points. But 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.

Inherent Risks

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.

  1. Pure Yield Pickup Swap

    A pure yield pickup swap is when bonds with lower returns and ...
  2. Rate Anticipation Swap

    A rate anticipation swap is type of swap in which bonds are exchanged ...
  3. Asset Swap

    An asset swap is a derivative contract through which fixed and ...
  4. Forward Swap

    A forward swap is an agreement between two parties to exchange ...
  5. Swap

    A swap is a derivative contract through which two parties exchange ...
  6. Reverse Swap

    A reverse swap is an exchange of cash flow streams that undoes ...
Related Articles
  1. Managing Wealth

    An In-Depth Look at the Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  2. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  3. Trading

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  4. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  5. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  6. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  7. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  8. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
  9. Investing

    A Guide To Real Estate Derivatives

    These instruments provide exposure to the real estate market without having to buy and sell property.
  10. Trading

    3 Key Markets To Follow When Trading FX

    With the increased interconnectivity of the global markets these days, it pays to understand market relationships.
  1. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  2. How do companies benefit from interest rate and currency swaps?

    Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >>
  3. How do currency swaps work?

    Learn how a currency swap works, including who uses these transactions, and the mechanics and purpose of the different cash ... Read Answer >>
  4. How does an entrepreneur choose a business structure?

    Learn more about interest rate swaps and currency swaps, how these swaps are used and the difference between interest rate ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center