Total Return Swap (TRS)

Author: Financial-edu.com

A Total Return Swap (TRS) is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets in exchange for periodic cash flows, typically a floating rate such as LIBOR +/- a basis point spread and a guarantee against any capital losses. A TRS is similar to a plain vanilla swap except the deal is structured such that the total return (cash flows plus capital appreciation/depreciation) is exchanged, rather than just the cash flows.

A key feature of a TRS is that the parties do not transfer actual ownership of the assets, as occurs in a repo transaction. This allows greater flexibility and reduced up-front capital to execute a valuable trade. This also means Total Return Swaps can be more highly leveraged, making them a favorite of hedge funds.

Total Return Swaps (TRS) are also known as Total Rate of Return Swaps (TROR).

Market Participants

The Total Return Swap market is strictly institutional over the counter (OTC). Market participants include investment banks (Goldman Sachs, JPMorganChase), commercial banks (Bank of America, Sumitomo), mutual funds (Prudential, Merrill Lynch Asset Management), hedge funds, funds of funds, private equity funds, pension funds (CalPers), university endowments (Harvard, University of California), credit card lenders (American Express, MBNA/Bank of America), insurance companies (AIG, State Farm), governments, non- governmental (NGO) organizations (World Bank, Inter-American Development Bank), home loan banks (FHLB, Fannie Mae, Freddie Mac), and the Treasury departments of large multinational corporations (Wal-Mart, British Petroleum). A variety of special purpose vehicles (SPVs) such as CDOs and real estate investment trusts (REITs) also participate in the TRS market.

The TRS market was traditionally between commercial banks where one party (Bank A) had exceeded its balance sheet limits, and the other (Bank B) had balance sheet capacity available. Bank A could shift assets off its balance sheet synthetically and gain additional income with less risk. Bank B could "lease" the assets of Bank A by paying some regular cash flows and offering a guarantee against any capital losses.

In the last 10 years, hedge funds and special purpose vehicles have become a major force in the TRS market. Now the most common use of a TRS is for "leveraged balance sheet arbitrage", whereby a hedge fund lacking a large balance sheet and seeking leveraged exposure to particular assets pays for that exposure by "leasing" the assets from a major bank, mutual fund, or securities dealer. The hedge fund hopes to generate high asset returns without having to tie up its capital by buying those assets for its own account. The bank, fund, or dealer hopes to generate additional cash flow by charging a spread over and above the market returns it receives from lending or other activities, and receiving a guarantee against depreciation of the assets.

A TRS can be structured on any type of reference asset, including single equities, indexes, leases, oil-backed credit obligations, baskets of corporate bonds, mortgages, municipal bonds, other swaps or derivatives, real property, credit card ABS, residential MBS, CDO notes, investment grade convertible bonds, etc. This makes the range of potential market participants extremely broad.

TRS Transaction Structure

A TRS is made up of two legs, the Return Leg (or Total Return Leg) and the Funding Leg. The reference asset or basket of assets exists on the Return Leg. The cash flow payment stream exists on the Funding Leg.

The Return Leg is generally made up of two components: cash flows and capital appreciation of the reference asset(s). The Funding Leg also has two components: floating coupons based on LIBOR +/- a spread and payments to offset any capital depreciation of the reference asset(s).

Additional legs may be structured to account for reinvestment of returns, interest payments on collateral / haircuts, multi-currency flows, or differing payment schedules. Fees, spreads, principal payments, etc. may be added in a customized structure.

The Return Leg counterparty is called the Total Return Payer, Swap Seller, Buyer of protection, or Beneficiary. Here, we will use the term Total Return Payer or TRP. The TRP (typically a bank, fund, or dealer) has a long position in the reference asset or basket of assets, holding them on its balance sheet. The TRP "buys protection" on these asset returns by agreeing to pay all of the future returns of the reference asset(s) in exchange for a floating stream of payments, usually LIBOR +/- a spread, plus a guaranteed offset of any capital losses incurred by the reference asset(s). The TRP gives up one set of expected future returns (capital appreciation, coupons, fees, dividends, etc.) in exchange for another set of future returns (LIBOR coupons +/- a spread) and capital loss insurance. This allows the TRP to lock in the value of its asset(s) and receive additional income.

The Funding Leg counterparty is called the Total Return Receiver, Swap Buyer, Seller of protection, or Guarantor. Here, we will use the term Total Return Receiver or TRR. The TRR seeks exposure to the returns of the reference asset or basket of assets, but does not want to purchase and hold them on its balance sheet. This party "sells protection" on the TRP's asset(s) by taking a synthetic long position in the asset(s) and making regular floating cash flow payments and capital loss guarantee payments to the TRP. The TRR seeks leveraged returns, and will pay for access to those returns, while taking on the risk of capital losses.

Total Return Payers are usually large institutions with big balance sheets such as commercial banks, investment banks, mutual funds, securities dealers, and insurance companies. Total Return Payers have lower cost of funding than Total Return Buyers, but their returns are often limited by regulatory capital requirements or conservative strategies. By "leasing" a portion of its strong balance sheet with a TRS, a TRP can achieve higher returns while ensuring against capital losses.

Total Return Receivers are usually aggressive hedge funds, specialty asset managers, and CLO special vehicles who accumulate leveraged credit and sell off tranches to investors. TRRs seek maximum returns but they lack the large balance sheets of TRPs. A TRS allows a TRR to synthetically generate higher returns using leverage, while avoiding the transaction and administrative costs associated with buying the assets or entering into repo transactions.

The exchange of cash flows and risks are explained below:

Total Return Payer (TRP): - Owns reference asset(s) - Has lower cost financing - Pays total return of asset(s) - Receives LIBOR +/- spread - Receives payments to offset any capital losses - Takes on interest rate risk - Transfers away asset return risk

Total Return Receiver (TRR): - Does not own reference asset(s) - has a weaker balance sheet or uses balance sheet leverage - Has higher cost financing - Receives total return of asset(s) - Pays LIBOR +/- spread - Pays for any capital losses - Takes on asset return risk - Takes on interest rate risk

TRS deals are typically structured with a notional amount, start date, end date, and periodic dates where asset returns are swapped for cash flows. The notional amount is defined at the start as the market value of asset(s) on the Return Leg. The parties establish a regular payment calendar for transfer of net returns. For example, the parties may set a quarterly payment calendar defined by LIBOR coupon dates. On those dates, the Total Return Payer (or a specified third party) will mark-to-market the capital appreciation/depreciation and accumulated cash flows of the Return Leg asset(s). The Total Return Receiver will calculate the required coupon consisting of LIBOR +/- a spread. Value of the reference asset(s) is determined on a periodic basis by mark-to-market using dealer quotations, independent pricing data, market surveys, or independent valuation. The parties will then exchange the net difference between the value of the two legs. At expiration date of the TRS, the parties will exchange the remainder of net returns and continue on separately as if nothing had happened.

Where the reference asset is a security with a risk of default, such as a corporate bond or basket of bonds, the TRS agreement will normally set forth various payments and valuation steps required upon default. The TRS agreement may simply terminate, and the parties exchange cash payments according to the value of the defaulted assets. There may be an exchange of cash or physical delivery of the defaulted bonds. The Total Return Payer may substitute another security for the defaulted one and continue the TRS arrangement. A lump sum payment may be due. The Total Return Receiver may have the option to purchase the defaulted loan or bond from the Total Return Payer and then deal directly with the defaulted loan obligor. There are many potential variations, making a TRS attractive for parties focused on specific unique asset returns.

Total Return Swap Examples

In a Bank Loan TRS, a large bank such as Barclays (the Total Return Payer) purchases a loan. It then enters into a TRS with an investor (the Total Return Receiver). The bank pays all the interest and realized capital gains to the Seller, minus a "funding charge" (akin to an access fee to the bank's balance sheet). The investor pays LIBOR plus a spread, plus any realized capital losses to the bank. Initial collateral (the "haircut" or "Independent Amount" in swap language) of between 15% and 80% is paid to the bank by the investor at the inception of the TRS. The bank holds this collateral in a separate account and pays the investor periodic interest at the Fed Funds Effective Rate. Collateral treatment is typically "full recourse", meaning the investor must post additional collateral if the asset value drops, or may withdraw collateral if the asset value increases. The reference assets (loans) are periodically marked to market using LoanX, LPC, or dealer quotes. A Bank Loan TRS can be executed on a single loan (typical trade size US$5-10MM, up to $50MM) or a portfolio of loans (typical trade size US$250-750MM, up to $1B+). In both cases, a TRS is more flexible than buying a loan or investing in a Collaterized Loan Obligation (CLO). If the TRS is based on a portfolio of loans, the investor must maintain a set of portfolio criteria for the life of the TRS, consisting of percentage of senior secured vs. unsecured/high yield bonds, maximum obligor exposure, maximum industry exposure, minimum rating, and average portfolio rating. A Bank Loan TRS can be structured on a variety of loans, including par term and revolving loans, second lien loans, stressed and distressed loans, middle market and direct financing loans, high yield bonds, and international loans.

In a Capital Structure Arbitrage TRS a hedge fund (Total Return Receiver) focused on fixed income will use a TRS to synthetically "purchase" a basket of debt from a bank (Total Return Payer) on leverage, gaining exposure to a particular market segment such as mid-size private industrial company loans. The fund may then take a short position in similar risky unsecured bonds, or purchase credit default swaps (CDS) on similar companies to shift away default risk. The goal may be to create a "positive carry" situation where post-deal cash flows to the investor are higher than those paid to the bank. Alternatively, the hedge fund may anticipate the spread between high-grade and low-grade bonds will widen if the overall credit environment deteriorates, thereby gaining more on the drop in unsecured debt than the drop in secured debt.

In a Moderate Leverage Par TRS a leveraged loan fund (Total Return Receiver) uses a TRS to synthetically "purchase" a portfolio of debt form a bank (Total Return Payer), with a 4x-5x target leverage. This allows the fund to increase yields, with a target of 1%-1.5% of consistent returns per month. The fund will typically diversify broadly and engage in various derivatives arrangements to reduce portfolio risk while generating high yields.

In a High Leverage Par TRS a leveraged loan fund (Total Return Receiver) uses a TRS to synthetically "purchase" debt from a bank (Total Return Payer) with a 10x target leverage. The fund buys only the highest quality debt, diversifies broadly, and engages in various derivatives arrangements to reduce portfolio risk while generating high yields of 15-20% per year.

In a Distressed Debt TRS a hedge fund (Total Return Receiver) uses a TRS to synthetically acquire exposure to high yield or underperforming loans with the hope that the obligors will return to normal payment patterns. As the loan quality increases, so does the mark-to-market value and cash flows, creating the potential for both high capital gains and growing cash flows. Since the loans are purchased in distressed state, the downside may be limited for the investor, and the bank (Total Return Payer) is happy to generate more reliable cash flows and protect against total loss in the event of bankruptcy of the obligors.

In a Commercial Mortgage-Backed Securities (CMBS) TRS an asset manager (Total Return Receiver) seeking exposure to the mortgage market enters into a TRS with a mortgage dealer or lender (Total Return Payer). The reference asset may be the Lehman Aggregate CMBS Index, Bank of America CMBS Index, the NCREIF Property Index (private commercial real esate), 144A private transaction mortgages, unique mortgage portfolios or baskets, or a single large commercial or industrial mortgage. The asset manager hopes the mortgage market or a segment thereof will rise faster than floating rates, thereby gaining on the higher growth of asset value above the lower growth of financing rates.

In a Commodity Index TRS the investor (Total Return Receiver) pays a money market rate plus fees to a counterparty (Total Return Payer) in exchange for the total return of a specified commodity index such as the Dow Jones-AIG Commodity Index or Goldman Sachs GSCI Commodity Index.

In a Temporary Negative View TRS the Total Return Payer has a long term position in an asset, but believes that its value will decrease for a period of time and wants to protect against that drop in value. The Total Return Payer enters into a TRS with a counterparty who has the opposite opinion. The duration of the TRS is shorter than the intended holding period of the asset, allowing the Total Return Payer to maintain its long term position but achieve protection against its drop in value and potentially earn additional returns in the near term.

In a Synthetic Repo TRS the parties actually transfer ownership of the reference asset(s) from the initial owner (Total Return Payer) to the investor (Total Return Receiver), like a repo transaction. A Synthetic Repo TRS may occur in a single transaction or multiple transactions, for example a repo plus a related swap agreement. This may be done where the investor requires certain benefits of ownership, such as preferred stock voting rights or dividend receipts, or where the asset owner needs to get illiquid assets off its books quickly but the investor does not want to service them or deal with transfer costs. The investor never takes possession of the asset(s), leaving them under the control of the original owner, who agrees to provide ongoing asset management. Other potential reasons for a Synthetic Repo TRS include regulatory or tax arbitrage, cross-border asset transfer limitations, or simply limited time to execute a trade.

Other TRS Examples - Airplane Lease TRS - High Yield Bond Basket TRS - Dividend-Paying Equity Portfolio TRS - Insurance Policy TRS

TRS Similarities to Other Derivatives

In standard format, a TRS somewhat resembles a Credit Default Swap (CDS). Both a TRS and CDS are off- balance sheet and relate to the potential for default if the TRS reference asset is a loan or bond. As a result, a TRS is often characterized as a credit derivative. However, a TRS protects against loss in asset value (not necessarily related to default), while a CDS only protects against loss caused by specific credit default events. TRS also has non-standard terms, whereas a single name CDS normally follows standard ISDA documentation.

A TRS may resemble a Collaterized Debt Obligation (CDO) Tranche. In a CDO the investor takes an equity position in a fixed income reference portfolio, just as the TRS Total Return Receiver may take a synthetic position in fixed income reference asset(s). However, a TRS differs in the fact that it has complete flexibility in portfolio structure, terms, maturity, and unwinding mechanism. A TRS is inherently off-balance sheet for the Total Return Receiver whereas a CDO, CBO, or CLO investment usually is not. A TRS has exposure to the total returns of all reference assets compared to a CDO investment, which has exposure only to the particular tranche (Super Senior, Senior, Mezzanine, Junior/Equity).

A TRS is similar to a Vanilla Interest Rate Swap if the TRS reference asset is a loan or bond. However, in an Interest Rate Swap, the spread charged to account for differences in the expected future value of the interest payment legs includes the risk of default on the underlying fixed income instruments. In a TRS, the Total Return Receiver pays LIBOR +/- a spread, with the spread amount unrelated to the potential default on the reference asset(s) since that is treated separately in the capital depreciation payments. Furthermore, in an Interest Rate Swap, only the net interest payments are exchanged, whereas in a TRS the total returns of the reference asset(s) are exchanged.

TRS Valuation and Cash Flows

A Total Return Swap (TRS) is initially structured so the Net Present Value (NPV) to both parties is at or close to zero. As time progresses, the TRS gains or loses value on each leg so one or the other counterparty obtains a profit.

Payments Received by Total Return Receiver: - If reference asset is a bond, the bond coupon - The price appreciation, if any, of the reference asset since the last fixing date - If the reference asset is a bond that defaulted since the last fixing date, the recovery value of the bond - Interest on any collateral / haircut being held by the Total Return Payer

Payments Received by the Total Return Payer: - The periodic floating payment (usually LIBOR +/- a spread) - The price depreciation, if any, of the reference asset since the last fixing date - If the reference asset is a bond that defaulted since the last fixing date, the par value of the bond

The cash flows above are typically netted and exchanged in a single payment. If the counterparties have multiple trades together and are operating under a netting agreement, then the net cash flows from the TRS may be netted out with other trades and a single payment made covering all trades. Benefits of Total Return Swaps

The greatest benefit of a TRS is leverage. The parties do not transfer actual ownership of the assets, as occurs in a repo transaction. This allows reduced up-front capital to execute a valuable trade. This makes Total Return Swaps a favorite of hedge funds.

A TRS can be used as a synthetic funding instrument offering improved financing costs. For example, engaging in a repo transaction might cost LIBOR at 5.75% plus 125bp plus transaction fees of 0.25% plus bid/offer spread of 5bp, for a total of 7.3% to a hedge fund. A TRS may cost LIBOR at 5.75% plus 150bp spread to "lease" the bank's balance sheet assets, for a total of 7.25%. In addition, the hedge fund may save 5bp in asset servicing costs, reducing the expected financing cost to 7.2%.

Operational efficiency is another benefit of a TRS, as settlements, interest collection, payment calculations, consent requests, reporting, and tracking associated with transferring ownership of an asset can be avoided. Asset administration is left to the Total Return Payer so the Total Return Receiver never has to deal with these issues.

Total Return Swaps are highly flexible. A TRS can be based on virtually any asset or series of assets. Furthermore, the life of a TRS contract and its payment dates are up to the parties, and need not match the payment or expiration dates of the reference asset(s).

Total Return Swaps can provide access to otherwise inaccessible asset classes, such as new issue loans, hedge fund limited partnership interests, private equity securities, etc.

Risks of Total Return Swaps

Investment Return Risk is born by the Total Return Receiver in a Total Return Swap. While the Total Return Payer retains the reference asset(s) on its balance sheet, the Total Return Receiver assumes the risk of capital losses by making guarantee payments to the Total Return Payer that offset any drop in asset value.

Interest Rate Risk is born by both parties to a TRS. Payments made by the Total Return Receiver to the Total Return Payer are normally floating rate LIBOR +/- a spread. If LIBOR increases during the life of the TRS, the Total Return Receiver's coupon payments will increase. If LIBOR decreases, the Total Return Payer's coupon receipts will decrease. Interest Rate Risk is typically higher to the investor (TRR) who does not necessarily have direct access to LIBOR financing, whereas the bank (TRP) does. The TRR may therefore need to hedge its LIBOR risk through the use of interest rate derivatives such as FRAs, caps, floors, and futures.

Liquidity Risk may exist if the TRS terms specify physical delivery of assets between the parties. For example, if the TRS requires the bank (Total Return Payer) to deliver specific high yield bonds at expiration, and these bonds defaulted during the life of the TRS, it may be difficult to acquire them at reasonable valuation in the open market if the bank does not have them in its inventory. If the TRS reference asset is a mortgage or credit card loan, the obligor may have prepaid and retired its loan earlier than expected prior to the expiration of the TRS, requiring the bank to purchase a substitute loan or make a cash payment on the estimated present value of a loan retired in the past. Illiquid instruments are also difficult to mark to market, since there is a lack of comparative transaction data. This can cause valuation disagreements between the counterparties and interfere with efficient settlement.

Counterparty Risk can be a significant factor in certain transactions. Many hedge funds (Total Return Receivers) take leveraged risk to generate greater returns. If a hedge fund 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). Since most swaps are executed on large notional amounts between $10 million and $100 million, this could put the Total Return Payer (typically a commercial or investment bank) at risk of a hedge fund's default if the fund is not sufficiently capitalized. Hedge fund counterparty risk is accentuated due to secrecy and minimal or nonexistent balance sheet reporting obligations. Counterparty risk may be ameliorated by shortening the maturity of the TRS, increasing collateral required, or third party balance sheet auditing and verification.

Bankruptcy Risk may exist where the reference asset is a single large capital asset, such as a industrial building mortgage or airplane loan. If the borrower defaults or files for bankruptcy, the loan payments may terminate, effectively eliminating the asset returns to the Total Return Receiver and requiring large capital loss payments to the Total Return Payer. Total Return Swap Documentation

Total Return Swaps are documented using a standard International Swaps and Derivatives Association (ISDA www.isda.org) Master Agreement and Schedule, which governs swaps between two parties.

There is an additional Credit Support Annex (CSA), where the parties set forth the agreed collateral and credit terms. These terms are often unique.

The Swap Confirmation ("Confirm") is usually a customized document. The Confirm sets the actual trade terms of the TRS, which may vary widely depending on the reference asset(s) and parties. Counterparties with regular trading relationships often develop their own templates to speed transaction processing and ensure both parties clearly understand their payment obligations.