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Active bonds portfolio management attempts to take advantage of either superior bond selection or superior market timing. The former requires a bond portfolio manager who is capable of identifying mispriced bonds. The bond portfolio manager can buy underpriced bonds or sell overpriced bonds. The latter strategy requires a bond portfolio manager capable of predicting interest rate changes. Bond portfolio managers use swaps to implement either strategy.

A substitution swap replaces one bond with another bond that has very similar characteristics, such as coupon rate, time to maturity, rating quality, and call and sinking fund features. A bond is purchased if it is overpriced or sold if it is underpriced. The bond that is replaced is properly priced. The bond portfolio profits when the mis-priced bond moves to the proper equilibrium price.

An inter-market spread swap...