TRORs represent an off balance sheet transaction, they are becoming less common in the market.
The arrangement on this instrument is rather similar to a hire arrangement. Whereby the lessee receives the benefits without paying the upfront price of the asset she is enjoying. This analogy can be taken further. The consumer will be expected to pay any costs because of damage to the equipment.
Returning to the financial world while this analogy is still clear in our memory, the asset is some type of financial security usually a bond. The lessee is usually called an investor because she enjoys all the cash flow benefits from the security without actually owning the security. She would be said to receive the TROR. However the dark side of this arrangement is that she should make good any decline in price. This makes clear the advantage to the leaser, or TROR payer.
Who would have the underlying asset on their balance sheet. They are now protected against both adverse movements of the market and adverse credit developments.
The total return payer passes the total return of the security to the receiver. The payment is often based on a floating rate reference such as libor and the asset can either be a bond, loan, equity receivables or even a payment linked to an index.
The total return payer holds the reference asset on its balance sheet for the duration of the transaction and it will have created a short position in both the credit risk and market risk of the asset by virtue of selling the ‘TROR’ and so the net position is neutral.
Figure 3.3 shows the payments associated with this instrument.
Table 3.2 The term sheet of a default swap.
Detail Example
Default protection buyer European bank Default protection seller Insurance company
Reference obligation ABC Corporate 7% June 2010
Currency Euro
Buyer pays 100 bps on a quarterly Act/360 basis
Final maturity 5 years
Trade date Today
Effective date Trade dateone calender day
Seller pays upon credit event Physical delivery of asset for par
Credit event See Table 3.1
Documentation Standard ISDA agreement
Notional $100 million
TROR term sheet
Table 3.3 shows the typical features associated with a TROR, this is the so-called ‘term sheet’ which lays out the details of the trade for reasons of transparency.
Settlement
There are three ways of settling the TROR instrument:
• If a credit event occurs on the reference asset then a contingency payment is made equal to the difference between the original price and the recovery value. The difficulty here is the possibility of not being able to price. In which case the documentation must allow for the substitution of the price on a reference asset of comparable credit quality.
L 4.00%
L 0.75%
L 4.00%
Contingent payment
Term loan Bank Investor
Figure 3.3 TROR payments.
Table 3.3 The term sheet of a TROR.
Detail Example
Total return payer European bank Total return receiver Investment manager
Issuers Company A
Interest payable L30 bps
Final maturity 10 years
Trade date Today
Payer pays All cash flows on the reference FRN Receiver pays Premium based on a spread to libor Termination payment Notional(100%market value/100)*
Termination trigger Publicly available information of a credit event Calculating agent Total return payer
Documentation Standard ISDA agreement
Notional $100 million
*If positive, the receiver will make this payment; if negative, the receiver will be in receipt.
• Other methods include the protection buyer having to make a physical delivery of the obligation in return for payment of the face amount. The contract usually allows any one of a basket of obli- gations to be delivered. These are said to be ranked ‘Pari-passu’
because they have the same value on liquidation as a consequence of having an equal claim on the assets of the entity.
• More rarely the counterparties can fix the contingent payments in advance – this is known as binary settlement.
The total return receiver has a synthetic long asset. The term synthetic is employed because the investor is receiving the proceeds from the security just as if he owned it. At the maturity date of the security the receiver gets the difference in market value of the asset if positive, and pays if this is negative. In the event of a default prior to the maturity date of the TROR, then the agreement terminates and the receiver compensates the payer.
The total return receiver is said to make the payer ‘whole’ for the credit and market risk of the instrument. Either the investor can pay the dif- ference between the original price of the instrument and the current market price or he can take delivery of the defaulted reference asset and pay the buyer of protection the original price as compensation. Once either of these arrangements has occurred then the TROR terminates.
TRORs are often compared with a REPO arrangement, the reader should be wary of adopting this analogy. In a REPO arrangement one party agrees to sell securities in exchange for cash and repurchase the securities at a pre-specified price in the future. Obviously the seller has to pay interest on the cash for the duration of the agreement, the so-called REPO rate. Contrast this with a TROR where the receiver is not obligated to purchase the assets. Further there is no pre-arranged price for the reference asset at the maturity of the transaction.
The primary use of TRORs is that of financing positions. Indeed for most arrangements the net cash flow from the receiver’s perspective, subtracting the floating payments from the received income is positive.
This is a marvellous arrangement. The investor enters an agreement and receives a positive payment. Table 3.4 shows the return on the deal for various types of investors.
There are other benefits which we list below:
• The maturity of the synthetic asset can be tailored.
• Higher returns on capital because of their off balance sheet nature.
• Reduction of administrative costs.
• Exposure to a desired asset class, such as a loan, which otherwise would be denied.
Benefits to the payer:
• Investors unable to short securities can hedge a long position through paying the TROR.
• Long-term investors who feel the assets may underperform in the short term may enter into a TROR that has a shorter maturity than the asset.
• Benefits in some accounting regimes – losses can be deferred with- out risking further loss. Again the maturity of the TROR is less than the asset.
Funding opportunities
The sequence of Figures 3.4–3.6 illustrate how two parties can have comparative advantages by entering into a TROR swap. Either could directly buy the asset, but this would not be particularly attract- ive to the BB bank because of its high-financing cost. The AA bank on the other hand has an asset with a large credit risk. By entering the swap the BB has a better spread on the asset and the AA has a stronger credit on its balance sheet. In Figure 3.4 we illustrate the deal from each perspective.
Table 3.4 The economic returns for a TROR.
Leveraged fund Institution
Asset yield 10.5% 10.5%
Funding cost 9%
Collateral 5%
Leverage 10 1
Leverage return 15% (product of leverage with the 10.5%
return net of funding)
Asset TROR
BBB asset L 70 bps
Funding L 35 bps BB Institution
Asset TROR
BBB asset L 70 bps
Funding L 5 bps AA Bank
Figure 3.4 A TROR funding application.
Figure 3.5 shows the TROR transacted between the bank and the institution. This arrangement is financially the same as being ‘long’ the asset in the individual cases. However a significant advantage is now conferred, providing the asset and the BB institution have a low default correlation.
Finally Figure 3.6 illustrates the ‘synthetic’ asset for each counter- party. The institution has an unfunded asset as in Figure 3.4, but the periodic financing is five basis points cheaper. While the bank has a high- quality credit on its books; with a higher rating than the original asset.