Investors Would Do Well to Consider Bond Swaps : Strategy: An interest rate devalued bond is replaced with one with a higher coupon rate.

Even those who study the U.S. Tax Code only on the evening of April 14 know that the best investment provides a write-off without actually losing value.

Buying a house can be such an investment, since homeowners are allowed to deduct mortgage interest costs even as the house itself appreciates in value. But the Internal Revenue Service is seldom that generous in other investments.

But bondholders would do well to consider a “bond swap,� a once ordinary tax strategy made extraordinary by a cranky bond market and potentially lower capital gains taxes in 1995.

In a bond swap, an investor replaces a bond that has lost value amid rising interest rates with one that’s comparably priced but pays out more money each year because it has a higher coupon rate.

“It’s an old strategy but we’ve just experienced the worst bond market in about seven decades,� said Mark Bell, an independent financial planner in Chicago. “So a lot of people are sitting with losses inside their portfolios.�

Any bond showing a paper loss of at least a few thousand dollars may be a good candidate for a swap, according to financial planners. And while bond swaps aren’t just for experts, the advice of one is always wise when decoding IRS rules. (For example, if one of your devalued bonds is part of the troubled Orange County debt, you might want to wait.)

Say you bought $10,000 of 30-year bonds with a 6% coupon five years ago and new 30-year bonds have a 7% coupon. You could sell the old bonds for $8,600 and write off the $1,400 loss.

If you’re in a combined 37.4% federal and state tax bracket, you would save $524 in taxes, so your actual loss would be $876, said Linda Valentic, a financial planner in Walnut Creek. The new bonds would bring $100 a year more in income and recoup the loss within nine years.

In a swap, bondholders are allowed to do what stockholders only dream about: Sell a poorly performing investment for the tax loss and buy it back, hoping it will perform better in the future.

Swapping a bond for one with a higher coupon guarantees a better rate and, while the IRS won’t give the break if bondholders repurchase the exact same security, you can get around buyback rules by swapping for one that is similar in character and price.

Considering that the Republicans are more likely to lower capital gains taxes now that they hold the majority in Congress, “it makes sense to use swaps this year, because next year it won’t be as valuable,� said Loren Hansen of Northern Trust Co.

Swaps also let investors anticipate interest rate changes. Since longer-maturing bonds typically yield more than shorter-maturing bonds, investors who expect rates to fall can swap out of short-term bonds to lock in higher yields or swap into shorter maturities if they expect rates will rise.

When pondering a bond swap, investors also have to consider the rate at which their personal income is taxed, since that determines how much savings a tax loss would bring. If you’re in the highest 1994 federal tax bracket, lowering the amount of your income that’s taxed at 39.6% would bring more savings than for someone whose income is taxed at a lower rate.

“If you can get rid of a poor-performing bond, improve your overall return and get a tax break, then there is incentive to make the change,� said Valentic, who also warns, “If you have to lose a dollar to save 28 cents, it’s not a smart way to build wealth.�

There are other potential pitfalls in swapping bonds, one of which results directly from the strategy’s popularity. Because tax selling has depressed bond prices, swaps are becoming less attractive to prospective sellers, said financial planner Joel Isaacson, who is holding off swaps for now.