What Is a Bond Swap?
A bond swap consists of selling one debt instrument and using the proceeds to purchase another debt instrument. Investors engage in bond swapping with the goal of improving their financial positions in the context of a fixed-income portfolio.
For example, bond swapping can reduce an investor’s tax liability, give an investor a higher yield, change a portfolio’s duration, or help an investor to diversify their portfolio to reduce risk.
A bond swap occurs when the proceeds from the sale of one debt instrument are used to subsequently purchase another debt instrument.
Bond swaps can be used to achieve tax benefits, known as a tax swap; or else be used to take advantage of changing market conditions.
Bond swaps might also be used to shorten or extend maturities or duration of a bond or improve the credit quality of a fixed-income portfolio.
Investors must be careful to avoid wash sales during these types of transactions.
How a Bond Swap Works
When an investor engages in a bond swap, they are simply replacing a bond in their portfolio with another bond using the sale proceeds from the longer-held bond. There are a number of reasons an investor will swap bonds in their portfolio, one of which is to realize tax benefits. To do this, a bondholder will swap bonds close to year-end by taking a loss on the sale of a depreciated bond and using that loss to offset capital gains on their tax returns. This bond swap strategy is referred to as a tax swap.
The investor can write-off the losses from the bond they sold to lower their tax liability, as long as they do not purchase a nearly identical bond as the one sold within 30 days of selling the previously held bond—the wash-sale rule.1 Generally, a wash sale can be avoided by ensuring that two of the following three characteristics of the bond are different: issuer, coupon and maturity.