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.