Total Return Swaps (TRS)

Total Return Swaps (TRS), sometimes known as a total rate of return swaps or TR swaps, are an on off-balance sheet transaction for the party who pays total returns composed of capital gains or losses plus the ordinary coupon or dividend, and receives LIBOR plus spread related to the counterparty’s credit riskiness on a given notional principal. The bank paying total returns is effectively warehousing, renting out its balance sheet while transferring economic value and risk to preferably an uncorrelated counterparty to the referenced assets. 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. It is  one of the principal instruments used by banks and other financial instruments to manage their credit risk exposure, and as such is a credit derivative. They are used as credit risk management tools, and also as synthetic repo instruments for funding purposes. For example, a bank that keeps a huge book of loans may want to reduce its economic exposure to some of its loans while keeping the relationship with its customers who have the loans. The bank can enter into a total return swap with a counterparty that desires to gain economic exposure to the high yield loan market.

Total Return Swaps (TRS)

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 (TRS) is a highly leveraged transaction (HLT) that motivates the receiver to take on the credit risk of referenced assets which are not actually owned, making them a favorite of hedge funds. The bank which is trying to reduce its concentration risk to a particular entity and free up regulatory capital may enter into TRS with a hedge fund which is willing to post five, ten or twenty percent collateral and/or mark-to-market the position frequently to mitigate counterparty risk to the bank on the notional principal.

The bank’s motivations are different from that of the hedge fund, and may include reducing its exposure without selling the reference asset, severing banking relationships with the client whose debt is being securitized by the bank, regulatory capital relief to free up capital, balance sheet management to originate other loans and earn origination fees, deferring unrecognized gains/losses on the referenced assets by paying total returns and receiving floating rate, and diversification of its risk.

The return received by the hedge fund is predicated on the amount of the change in the market value (MV) of the asset net of coupon (dividend), levered by the amount of collateral posted by the hedge fund. The leverage cuts both ways.  Assuming the underlying debt price appreciates, then the return will be magnified by the leverage factor. On the other hand, if the debt price falls owing to rising interest rates or to a downgrade of the issuer, the leverage factor will have a devastating negative impact on the return realized by hedge fund.

The amount of the collateral posted depends on the extent of bank’s desire to securitize the credit risk of the referenced asset. A bank may enter into Total Return Swaps (TRS) with a hedge fund posting five percent collateral that to some degree mitigates the counterparty risk, while a conservative bank may require larger ten, 15 or 20 percent collateral. Where the counterparty is highly-rated entity there will be no requirement for posting collateral.

A Total Return Swaps (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, Collateralized Debt Obligations (CDO) notes, investment grade convertible bonds, etc.  This makes the range of potential market participants extremely broad.

The TRS trade itself can be to any maturity term – that is, it need not match the maturity of the underlying (or reference) security. In a TRS, the total return from the underlying asset is paid over to the counterparty in return for a fixed or floating cash flow. This makes it slightly different to other credit derivatives such as credit default swaps, as the payments between counterparties to a TRS are connected to changes in the market value of the underlying asset, as well as changes resulting from the occurrence of a credit event.

As expected, the return realized by the receiver who is taking on the credit risk (risk of default), the market risk (interest rate risk due to rising interest rate), as well as the unique risk (possible downgrade of the debt issue) of the underlying debt instrument as a bank lays off all the risks to the receiver by paying total return while receiving LIBOR plus spread is extremely sensitive to the amount of collateral posted.