A bond swap is a situation in which a bondholder makes a decision to sell one or more currently held bonds and purchase other bonds that are considered to be of equal or similar market value. Both the purchase and the sale take place around the same time, effectively exchanging or swapping one bond or set of bonds for new ones.
There are several reasons why an investor may choose to engage in a bond swap. One of the more common motivations for engaging in a bond swap is in order to sell off a bond at the end of a calendar year. Often, this will be a bond that is performing below expectations, and may even be sold at a loss. The sale creates a tax write-off, as well as providing the revenue to purchase another bond of similar value that is showing promise of strong performance in the near future.
This practice of unloading a bond that is not performing well for one of similar value that is anticipated to make a profit helps to keep the overall value of the investment portfolio stable. The bond sale also creates a write off for taxes, which may prove advantageous. As a final advantage, the bond purchase that completes the task of the bond swap results in the acquisition of an asset that is expected to appreciate in value, which sets the stage for a more profitable year to come.
Bond swapping is also an efficient means of extending or shortening the maturity of the bonds in the investment portfolio. Depending on the goals and strategies that the investor has in mind, it may make perfect sense to sell off bonds with short term maturity dates with an equal number of bonds with a longer term date. As a tool to tailor the components of the portfolio to achieve particular returns within a given set of circumstances, the bond swap is easy to accomplish.
Bond swaps are also used to exchange bonds within the portfolio for other bonds with a different rating. The investor may choose to sell a bond with a higher rating and use the revenue to purchase a bond with a lower rating, again as a means of positioning the assets of the portfolio to comply with a given investment strategy.
