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.
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. … Read the rest