OR’STGSUEVIDNBOND SWAPPINGTechniques to lower your taxes and improve the quality of your portfolioANIOTE
WHAT IS A BOND SWAP?CONTENTSA bond swap is a technique whereby an investorWhat Is a Bond Swap?chooses to sell a bond and simultaneously purchase1another bond with the proceeds from the You Would Consider SwappingFixed-income securities make excellent candidates1for swapping because it is often easy to find twobonds with similar features in terms of credit quality,Swapping for Qualitycoupon, maturity and a bond swap, you sell one fixed-income holdingSwapping to Increase Yieldfor another in order to take advantage of current3market and/or tax conditions and better meet yourSwapping for Increased Call Protectioncurrent investment objectives or adjust to a change4in your investment status. A wide variety of swapsare generally available to help you meet your specif-Anticipating Interest Ratesic portfolio to Lower Your TaxesWHY YOU WOULD 6CONSIDER SWAPPINGSome Important Rules for Tax Swapping7Swapping can be a very effective investment tool to:Other Tax Strategies•increase the quality of your portfolio;9•increase your total return;How to Avoid a Wash Sale•benefit from interest rate changes; and9•lower your a Personal AppraisalThese are just a few reasons why you might find10swapping your bond holdings beneficial. AlthoughBond Swapping Appraisal Formthis booklet contains general information regarding11federal tax consequences of swapping, we suggestyou consult your own tax advisor for more specificAll information and opinions contained in this publication were produced by The Bondadvice regarding your individual tax Association from our membership and other sources believed by the Associationto be accurate and reliable. By providing this general information, The Bond MarketAssociation makes neither a recommendation as to the appropriateness of investing infixed-income securities nor is it providing any specific investment advice for any particu-lar investor. Due to rapidly changing market conditions and the complexity of investmentdecisions, supplemental information and sources may be required to make informedinvestment
an economic downturn, higher-quality bonds, whichSWAPPING FOR QUALITYrepresent greater certainty of repayment in difficultmarket conditions, will typically hold their value bet-A quality swap is a type of swap where you are look-ter than lower-quality to move from a bond with a lower credit qualityAlso, if a market sector or a particular bond hasrating to one with a higher credit rating or viceeroded in quality, it may no longer meet your per-versa. The credit rating is generally a reflection of ansonal risk parameters. You may be willing to sacri-issuer’s financial health. It is one of the factors in thefice some current income and/or yield in exchangemarket’s determination of the yield of a particularfor enhanced . The spread between the yields of bondswith different credit quality generally narrows dur-SWAPPING TO ing good economic times and widens when the econ-INCREASE YIELDomy weakens. So, for example, if you expect a reces-sion you might swap from lower-quality into higher-quality bonds with only a negligible loss of can sometimes improve the taxable or tax-Standard rating agencies classify most issuers’ likeli-exempt returns on your portfolio by employing ahood of repayment of principal and payment of inter-number of different bond-swapping according to a grading system ranging from, say,In general, longer-maturity bonds will typicallytriple-A to C (or an equivalent scale), as a qualityyield more than those of a shorter maturity will;guideline for investors. Issuers considered to carrytherefore, extending the average maturity of a port-good likelihood of payment are “investment grade”folio’s holdings can boost yield. The relationshipand are rated Baa3 or higher by Moody’s Investorsbetween yields on different types of securities,Service or BBB– or higher by Standard & Poor’sranging from three months to 30 years, can be plot-Ratings Services and Fitch. Those issuers ratedted on a graph known as the yield curve. The curvebelow Baa3 or below BBB– are considered “belowof that line is constantly changing, but you caninvestment grade” and the repayment of principaloften pick up yield by extending the maturity ofand payment of interest are less certain. Supposeyour investments, assuming the yield curve is slop-you own a corporate bond rated BBB (lower-invest-ing upward. For example, you could sell a two-yearment-grade quality) that is yielding % and youbond that’s yielding % and purchase a 15-yearfind a triple-A-rated (higher-investment-grade quali-bond that is yielding %. However, you should1ty) corporate bond that is yielding %.You couldbe aware that the price of longer-maturity bondsswap into the superior-credit, triple-A-rated bond bymight fluctuate more widely than that of short-termsacrificing only 30 basis points (one basis point isbonds when interest rates change. 1/100th of one percent, or .01%). Moreover, duringWhen the difference in yield between two bonds of1All examples are for illustrative purposes and are not representative ofdifferent credit quality widens (which often happensactual market
at the startof an economic expansion), a cautiousinterest rate environment. For example, you couldswap to a lower-quality bond could possibly enhancesell a bond with a short call, ., five years, andreturns. But sometimes market fluctuations createpurchase a bond with 10 years of call by causing temporary price discrepan-This will enable you to lock in your coupon for ancies between bonds of equal ratings. For example,additional five years and not worry about losingthe bonds of corporate issuers may retain the sameyour higher-coupon bonds in the near future. Youcredit rating even though their business prospectsmay have to sacrifice yield in exchange for theare varying due to transient factors such as a specif-stronger call industry decline, a perception of increased risk ordeteriorating credit in the sector or company. So,ANTICIPATING suppose you purchased in the past (at par) a 30-yearINTEREST RATESA-rated $50,000 corporate bond with a %coupon. Assume that comparable bonds are nowIf you believe that the overall level of interest rates isbeing offered with a % coupon. Assume that youlikely to change, you may choose to make a swapcan replace your bond with another $50,000 A-rateddesigned to benefit or help you protect your bond having the same maturity with % coupon. By selling the first bond and buyingIf you believe that rates are likely to decline, it maythe second bond you will have increased your annu-be appropriate to extend the maturity of your hold-al income by 25 basis points ($125). Discrepanciesings and increase your call protection. You will bein yield among issuers with similar credit ratingsreducing reinvestment risk of principal and position-often reflect perceived risk in the for potential appreciation as interest rates trendThese discrepancies will change as market condi-down. Conversely, if you think rates may increase,tions and perceptions might decide to reduce the average maturity ofholdings in your portfolio. A swap into shorter-matu-SWAPPING FORrity bonds will cause a portfolio to fluctuate less inINCREASED CALL value, but may also result in a lower should be noted that various types of bonds per-form differently as interest rates rise or fall, and maybe selectively swapped to optimize may achieve other investment objectives,Long-term, zero-coupon and discount bonds performsuch as building a more diversifiedportfolio, orbest during interest rate declines because their pricesestablishing bettercall protection. Call protection isare more sensitive to interest rate changes. Floating-useful for reducing the risk of reinvestment atrate, short- and intermediate-term, callable and premi-lower rates, which may occur if an issuer retires,um bonds perform best when interest rates are risingcalls or pre-refunds its bonds early. Call protectionbecause they limit the downside price volatilityswaps are particularly advantageous in a declining45
involved in a rising yield environment; their price fluc-but not identical, characteristics. For example,tuates less on a percentage basis than a par or dis-assume you own a $50,000, 20-year, triple-A-ratedcount bond. municipal bond with a % coupon that you pur-chased five years ago at par. If interest ratesHowever, you should remember that rate-anticipationincrease (such that new bonds are now being issuedswaps tend to be somewhat speculative, and dependwith a % coupon), the value of your bond will fallentirely on the outcome of the expected rate approximately $47,500. If you sell the bond, youMoreover, shorter- and longer-term rates do not nec-will realize a $2,500 capital loss, which you can useessarily move in a parallel fashion. Different economicto offset any capital gains you have realized. If youconditions can impact various parts of the yield curvehave no capital gains, you can use the capital loss todifferently. To the extent that the anticipated rateoffset ordinary income. You then purchase in thechange does not come about, a decline in marketsecondary market a replacement triple-A-rated %value could bond (from a different issuer), maturing in15 years, at an approximate cost of $47,500. YourSWAPPING TO LOWERyield, maturity and quality of bond will be the sameYOUR TAXESas before, plus you will have realized a loss that willsave you money on taxes in the year of the bondsale. Of course, if you hold the new bond to maturi-Tax swapping is the most common of all , you will realize a $2,500 gain in 15 years, taxableAnyone who owns bonds that are selling below theiras ordinary income at that time. By swapping, youamortized purchase price and who has capital gainshave converted a “paper” loss into a real loss thator other income that could be partially, or fully, offsetcan be used to offset taxable a tax loss can benefit from tax may have realized capital gains from the sale ofSOME IMPORTANT RULESa profitable capital asset (., real estate, your busi-FOR TAX SWAPPINGness, stocks or other securities). Or you may expectto sell such an asset at a potential profit in the nearfuture. By swapping those assets that are currentlyUnder current tax law, the maximum tax rate ontrading below the purchase price (due to a rise inlong-term capital gains is lower than the maximuminterest rates, deteriorating credit situation, etc.) yourate on short-term capital gains. In order to be enti-can reduce or eliminate the capital gains you wouldtled to the lower long-term capital gains rate, a tax-otherwise have paid on your other profitable transac-payer must hold the asset for more than one in the current tax year. Because of ongoing discussions concerning possiblechanges in the tax treatment of capital gains,The traditional tax swap involves two steps: (1) sell-ing a bond that is worth less than you paid for it and(2) simultaneously purchasing a bond with similar,67
investors should consult their tax advisor for up-to-OTHER TAX STRATEGIESdate losses from swap transactions are reflectedChanges in the tax laws always present an opportu-on Schedule D of your tax return. If you have short-nity to review your bond or long-term capital gains, the losses from theInvestors who expect their tax rate to increase willswap transactions will offset these gains first —frequently swap taxable bonds for tax-exemptlong-term losses will offset long-term gains, and(municipal) bonds. This is done with the expectationshort-term losses will offset short-term gains; netthat tax-exempt bonds will become relatively morelosses in either category will then offset gains in thedesirable in the marketplace than fully taxable bondsother category. If the net result is an overall capitaland will benefit from price , the excess loss can be used to offset ordinaryincome dollar-for-dollar (up to a maximum ofInvestors not subject to the Alternative Minimum$3,000). If an investor has both net short-term andTax (AMT) can obtain additional yield by purchas-net long-term capital losses, the ordinary income ising municipals that are subject to that tax. Taxpayersfirst offset by the short-term capital losses, then bywho are subject to AMT can save taxes by swappingthe long-term losses. Excess capital losses can beto non-AMT forward indefinitely to reduce capital gainsliability and ordinary income in future TO AVOID A WASH SALEThe tax basis of the new bonds will be their cost (theprice paid for the bonds). If the new bonds are boughtat a discount and held to maturity, or are sold at aThe Internal Revenue Service will notrecognize aprice higher than their cost, a taxable gain will oftentax loss generated from the sale and repurchaseresult, unless also offset by losses. To the extent suchwithin 30 days before or after the trade or settle-gain represents accrued market discount, it will bement date of the same or a substantially identicaltaxed as ordinary income, with the balance treated assecurity — typically called a “wash sale.” While thecapital “substantially identical” has notbeen explicit-Ask your tax advisor about the use of original-issuely defined in this context, two bonds have generallydiscount or market discount bonds, or the use ofnotbeen considered substantially identical if (1)bonds issued at a premium, in tax securities have different issuers, or (2) thereare substantial differences in either maturity orcoupon
FOR A PERSONALBOND SWAPPING APPRAISALAPPRAISAL FORMTo learn more about what bond swapping may meanFill out both sides of this appraisal form and return itto you, simply complete the enclosed appraisal formto your account return it to your financial CODESTATE OF RESIDENCEHOME TELEPHONEWORK TELEPHONEACCOUNT NUMBERSwap Objective and you wish to establish a tax loss______________or realize a gain? you wish to improve quality? you wish to increase yield? you wish to increase call protection? there a change in your tax status? is your tax bracket? type of bond are you swapping? you have any other specific investment parame-ters, please comment:________________________________________________________________________________________To accomplish any of these objectives are you will-ing to... maturity? credit ratings?_______YES______NO3. Invest additional funds?_______YES______NO 1011
40 Broad Street, New York, NY Office: 1445 New York Avenue, NWWashington, DC ©1998, 1999 The Bond Market Association. All reproduction and other rights FOR REVIEWFACE AMOUNTISSUER AND DESCRIPTIONCOUPONMATURITY DATEPURCHASE COSTDATE OF PURCHASECUSIP NUMBERPlease photocopy this form if you have more entries.
