An Introduction to Total Return Swaps

What is a Total Return Swap?

A Total Return Swap (TRS) is an agreement in which one party makes periodic floating rate payments to a counterparty in exchange for the total return realised on a reference asset, which includes both the income it generates and any capital gains. It is a means of transferring the total economic exposure, including both the market and credit risks of the underlying asset between two parties.

The payer of the TRS can eliminate all the economic exposure of the asset without having to sell it, while the receiver of the TRS, on the other hand, can access the economic exposure without having to buy the asset. The reference assets can be indices, bonds (emerging market, sovereign, bank debt, mortgage-backed securities, corporate, municipal, etc.), loans, equities, real estate receivables, lease receivables, commodities etc.

Features of a TRS

The Total Return of a reference asset includes all cash flows that stream from it as well as the capital appreciation or depreciation of the reference asset.

The Floating Rate is a reference interest rate, e.g. the Nigerian Inter-bank Offered Rate (NIBOR) plus or minus a spread.

The Total Return Receiver (TRR) is the party that agrees to make the floating rate payments and receive the total return. The TRRs are usually aggressive hedge funds, specialty asset managers and collaterised loan obligation special purpose vehicles (SPVs), who accumulate leveraged credit spreads and sell off tranches to investors1.

The Total Return Payer (TRP) is the party that agrees to receive the floating rate payments and pay the total return. The TRPs are usually large institutions such as investment banks, commercial banks, mutual funds, securities dealers and insurance companies.

Other market participants in a TRS include: Fund of Funds, Private Equity Funds, Pension Funds, Credit Card lenders, University Endowments, Governments, Non-Governmental Organisations and special purpose vehicles such as Collaterised Debt Obligations and Real Estate Investment Trusts.

Structure of a TRS Transaction

In order to purchase the reference asset, the TRP must borrow capital. The dealer will raise cash from the capital market at a funding cost (usually linked to the inter-bank offered rate) and this cash will flow right out again to purchase the reference asset. The asset provides both interest income and capital gains or losses, depending on its price fluctuations.

A TRS has two payment legs between the payer (TRP) and receiver (TRR); the reference asset or a basket of assets exists on the “total return leg” and the interest payment, linked to the inter-bank offered rate, exists on the “funding leg”.

On the “total return leg”, the payer has a long position in the reference asset, holding it on its balance sheet, so it buys protection on the asset and agrees to pay the receiver all the future returns of the reference asset plus any appreciation in its value. In exchange, on the “funding leg”, the receiver seeks exposure to the returns of the reference asset or basket of assets, but does not want to acquire or hold in its balance sheet. The receiver will sell protection on the reference asset by taking a synthetic long position in the asset, agreeing to make regular floating cash flow payments to the payer (inter-bank offered rate +/- a spread) including any depreciation in the value of the asset and compensation for any default losses.

Benefits of a TRS

One of the major benefits of a TRS is leverage. A TRS allows the receiver to synthetically generate higher returns using leverage, while avoiding transaction and administrative costs associated with buying the assets or entering into repurchase agreement (repo) transactions. A TRS can be viewed as a form of credit protection that offers more risk reduction than a CDS4. With a TRS, the reference asset owned by the dealer is protected from declines in value as the investor must reimburse the dealer for any decline in the value of the reference asset.

Diversification is another draw to a TRS. The receiver can achieve the same economic exposure to a diversified basket of assets in one swap transaction that would otherwise take several cash market transactions to achieve.

It is highly flexible as it can be based on virtually any asset or series of assets It can also be used as a synthetic funding instrument offering improved financing costs. The payer may be able to lock in profits by entering into a TRS transaction. This occurs whenever the payer has a funding cost that is less than the payment it receives in the TRS. The receiver is also able to obtain good financing rates as their exposure to the reference asset is financed at a spread to the inter-bank offered rate, which is a lower cost than if they financed an outright purchase of the reference obligation.

The investor (TRR) can also take advantage of the dealer’s (TRP) better judgment in acquiring the reference asset.

Drawbacks of a TRS

The major drawbacks associated with a TRS lies in the risks associated with them. They include:

Interest Rate Risk, which is borne by both parties to a TRS. Payments made by the receiver to the payer are normally floating rate (inter-bank offered rate +/- a spread).  If inter-bank offered rate increases during the life of the TRS, the receiver’s coupon payments will increase.  Likewise, if inter-bank offered rate decreases, the payer’s coupon receipts will decrease.

Investment Return Risk is another drawback of a TRS usually borne by the receiver. As a result of the payer holding the reference asset on its balance sheet, the receiver assumes the risk of capital losses as it has to make guaranteed payments to the payer to offset any drop in asset value.

Counterparty Risk could occur if a Hedge Fund, for instance, makes multiple TRS investments in similar assets. Any significant drop in the value of those assets would leave the Fund in a position of making ongoing coupon payments plus capital loss payments against reduced or terminated returns from the asset(s).

Liquidity Risk could exist if the terms of the TRS contract specify the physical delivery of the reference asset and the asset defaults during the life of the TRS. This could pose a problem acquiring the reference asset at a reasonable valuation in the open market.