What is a Total Return Swap (TRS)?
A Total Return Swap is a contract between two parties who exchange the return from a financial asset between them. In this agreement, one party makes payments based on a set rate while the other party makes payments based on the total return of an underlying asset. The underlying asset may be a bond, equity interest, or loan. Banks and other financial institutions use TRS agreements to manage risk exposure with minimal cash outlay. However, in recent years, total return swaps are becoming more popular due to the increased regulatory scrutiny after the alleged manipulation of credit default swaps (CDS).
In a TRS contract, the party receiving the total return gets any income generated by the financial asset without actually owning it. The receiving party benefits from any price increases in the value of the assets during the lifetime of the contract. The receiver must then pay the asset owner the base interest rate during the life of the TRS. The asset owner forfeits the risk associated with the asset but absorbs the credit exposure risk that the asset is subjected to. For example, if the asset price falls during the lifetime of the TRS, the receiver will pay the asset owner a sum equal to the amount of the asset price decline.
Structure of a Total Return Swap Transaction
A TRS contract is made up of two parties, i.e., the payer and the receiver. The payer may be a bank, hedge fund, insurance company, or other cash-rich, fixed income portfolio manager. The total return payer agrees to pay the TRS receiver the total return on an underlying asset, while being paid LIBOR-based interest returns from the other party, the total return receiver. The underlying asset may be a corporate bond, bank loan, or sovereign bond.
The total return to the receiver includes interest payments on the underlying asset, plus any appreciation in the market value of the asset. The total return receiver pays the payer (asset owner) a LIBOR-based payment and the amount equal to any depreciation in the value of the asset (in the event that the value of the asset declines during the life of the TRS – no such payment occurs if the asset increases in value, as any appreciation in the asset’s value goes to the TRS receiver). The TRS payer (asset owner) buys protection against a possible decline in the value of the asset by agreeing to pay all the future positive returns of the asset to the TRS receiver, in exchange for floating streams of payments.
Who Invests in Total Return Swaps
The major participants in the total return swap market include large institutional investors such as investment banks, mutual funds, commercial banks, pension funds, fund of funds, private equity funds, insurance companies, NGOs, and governments. Special Purpose Vehicles (SPVs) such as REITs and CDOs also participate in the market. Traditionally, TRS transactions were mostly between commercial banks, where bank (A) had already surpassed its balance sheet limits, while the other bank (B) still has available balance sheet capacity. Bank A could shift assets off its balance sheet and earn an extra income on these assets, while Bank B would lease the assets and make regular payments to Bank A, as well as compensate for depreciation or loss of value.
Hedge funds and SPVs are considered major players in the total return swap market, using TRS for leveraged balance sheet arbitrage. Usually, a hedge fund seeking exposure to particular assets pays for the exposure by leasing the assets from large institutional investors like investment banks and mutual funds. The hedge funds hope to earn high returns from leasing the asset, without having to pay the full price to own it, thus leveraging their investment. On the other hand, the asset owner expects to generate additional income in the form of LIBOR-based payments and getting a guarantee against capital losses. CDO issuers enter into a TRS agreement as protection sellers in order to gain exposure to the underlying asset without having to purchase it. The issuers receive interest on the underlying asset while the asset owner mitigates against credit risk.
Benefits of Total Return Swaps
One of the benefits of total return swaps is their operational efficiency. In a TRS agreement, the total return receiver does not have to deal with interest collection, settlements, payment calculations, and reports that are required in a transfer of ownership transaction. The asset owner retains ownership of the asset, and the receiver does not have to deal with the asset transfer process. The maturity date of the TRS agreement and the payment dates are agreed upon by both parties. The TRS contract maturity date does not have to correspond to the expiry date of the underlying asset.
The other major benefit of a total return swap is that it enables the TRS receiver to make a leveraged investment, thus making maximum use of its investment capital. Unlike in a repurchase agreement where there is a transfer of asset ownership, there is no ownership transfer in a TRS contract. This means that the total return receiver does not have to lay out substantial capital to purchase the asset. Instead, a TRS allows the receiver to benefit from the underlying asset without actually owning it, making it the most preferred form of financing for hedge funds and Special Purpose Vehicles (SPV).
Risks Associated with a Total Return Swap
There are several types of risk that parties in a TRS contract are subjected to. One of these is counterparty risk. When a hedge fund enters into multiple TRS contracts on similar underlying assets, any decline in the value of these assets will result in reduced returns as the fund continues to make regular payments to the TRS payer/owner. If the decline in the value of assets continues over an extended period and the hedge fund is not adequately capitalized, the payer will be at risk of the fund’s default. The risk may be heightened by the high secrecy of hedge funds and the treatment of such assets as off-balance sheet items.
Both parties in a TRS contract are affected by interest rate risk. The payments made by the total return receiver equal to LIBOR +/- an agreed upon spread. An increase in LIBOR during the agreement increases the number of payments due to the payer, while a decrease in LIBOR decreases the payments to the payer. Interest rate risk is higher on the receiver’s side, and they may hedge the risk through interest rate derivatives such as futures.
For further information on swap agreements and interest rate factors, see the following resources: