Bond swaps are done for many reasons (such as to improve income, improve quality, change maturity schedule, or enhance diversification). Thus, if the bond swap is worthwhile, it will be done for various economic reasons rather than simply for tax benefits. (Of course, there is nothing wrong with obtaining a tax benefit at the same time.) A tax benefit is often realized when an investor sells bonds that were acquired during a period when interest rates were lower than they were at the time of the swap. Because interest rates rose, bond prices fell, and the seller is able to generate a tax-deductible capital loss. The tax savings may be viewed as an ancillary benefit derived from the bond swap. A word of caution is in order, though: if you are considering a bond swap that will generate a tax-deductible capital loss, do not swap into a security classified by the Internal Revenue Service as basically identical to the one you sold until the appropriate time period has passed. Otherwise, the loss will be disallowed for tax purposes.Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD
In a bond swap, you buy one bond and sell another at the same time.
For example, you might sell one bond at a loss at year's end to get a tax write-off while buying another to keep the same portion of your portfolio allocated to bonds.
You may also sell a bond with a lower rating to buy one with a higher rating, or sell a bond that's close to maturity so you can buy a bond that won't mature for several years.