Finance

What is Total Return Swap?

Total Return Swap

A Total Return Swap (TRS) is a swap agreement in which one party makes payments based on a set rate either fixed or variable while the other party makes payments based on the return of an underlying asset which includes both income which it generates and capital gains. The underlying asset can be a bond, equity, or loan. Banks and other financial institutions use TRS agreements to manage risk exposure with minimal cash outflow. Though TRS has become more popular due to the increased regulatory investigation after it claims the manipulation of credit default swaps (CDS). The asset owner forfeits the risk connected with the asset but absorbs the credit exposure risk that the asset is subjected to.

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Arrangement of a Total Return Swap Transaction

A TRS contract is formed up of two parties, i.e. the payer and the receiver. The payer can be a bank, hedge fund, insurance company, or fixed income portfolio manager. The total return payer agreed to pay the TRS receiver the total return on an underlying asset who paid LIBOR-based interest. The underlying asset can be a corporate bond, bank loan, or sovereign bond.

The total return to the receiver includes interest payments and appreciation in the market value of the asset. The total return receiver paid the payer (asset owner) a LIBOR-based payment and any depreciation in the value of the asset (in case value of the asset declines during the life of the TRS – no such type of payment occurs if the asset increases in value, as any appreciation in the asset’s value goes to TRS receiver). The TRS payer (asset owner) has bought protection against a likely decline in the value of the asset by agreeing to pay all the future positive returns of the assets to the TRS receiver in exchange for floating streams of payments.

 

Investments in Total Return Swaps

The major participants in the total return swap market are large institutional investors such as investment banks, mutual funds, commercial banks, pension funds, private equity funds, insurance companies, NGOs, and governments. Special Purpose Vehicles (SPVs) such as CDOs who participate in the market. Traditionally, TRS transactions were mostly between commercial banks where bank ABC had already crossed its balance sheet limits, while the other bank XYZ still had available balance sheet capacity. Bank ABC could shift assets off its balance sheet and earn an extra income on these assets, while Bank XYZ will lease their assets and make timely payments to Bank ABC as well as compensate for depreciation or loss of value.

Hedge funds and SPVs are assumed to be the 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 the need to pay the full price to own it or we can say 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 purchasing it. The issuers receive interest in the underlying asset while the asset owner mitigates against the credit risk.

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Benefits of Total Return Swaps

One of the advantages of total return swaps is its operational efficiency. In a TRS agreement, the receiver does not have to deal with interest collection, settlements, payment calculations and reports which requires a transfer of ownership transaction. The asset owner maintains the 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 settled upon by both parties. The TRS contract maturity date does not have to keep in touch with the expiry date of the underlying asset.

The other main benefit of a total return swap is that it ensures 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, whereas there is no ownership transfer in a TRS contract. This means that the total return receiver does not have to lay out the substantial capital to purchase the asset. A TRS permits the receiver to benefit from the underlying asset without owning it which makes it the most preferred form of financing for hedge funds and Special Purpose Vehicles (SPV).

Risks Associated with a Total Return Swap

There are some types of risk that parties in a TRS contract are objected to. One of these is counterparty risk. When a hedge fund made various TRS contracts on similar underlying assets any decline in the value of these assets will lead to the reduced returns as the fund continues to make timely 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 risen by the high secrecy of hedge funds and the treatment of such assets as off-balance sheet items.

Both parties are affected by interest rate risk. The payments made by the total return receiver are equal to LIBOR +/- an agreed-upon spread. Increment in LIBOR during the agreement increases the payments due to the payer, while a fall in LIBOR decreases the payments to the payer. Interest rate risk is higher on the receiver’s side and they should hedge the risk through interest rate derivatives such as futures to mitigate the risk.

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Author: Yash Tanwar

About the Author: Commerce graduate from the University of Delhi who is currently pursuing FRM Part-1 2020. He wants to obtain a stronger track record of result making and gain something new skill sets that are applicable to Finance specifically in risk domain.

 

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