CHAPTER 5
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Total Return Swaps
total return swapis a swap in which one party makes periodic float- ing rate payments to a counterparty in exchange for the total return realized on a reference asset (or underlying asset). The reference asset could be one of the following:
■ Credit-risky bond ■ A loan
■ A reference portfolio consisting of bonds or loans ■ An index representing a sector of the bond market ■ An equity index
Our focus in this chapter is on total return swaps, where the refer- ence asset is one of the first four types listed above. We first explain how a total return swap can be used when the reference asset is a credit-risky bond and a loan. While these types of total return swaps are more aptly referred to as total return creditswaps, we will simply refer to them as total return swaps. When the bond index consists of a credit risk sector of the bond market, the total return swap is referred to as a total return bond index swap or in this chapter as simply a total return index swap.
We will explain how a total return index swap offers asset managers and hedge fund managers greater flexibility in managing a bond portfolio. In the appendix to this chapter we explain the pricing of total return swaps.
asset. The floating rate is a reference interest rate (typically LIBOR) plus or minus a spread. The party that agrees to make the floating rate pay- ments and receive the total return is referred to as the total return receiver or the swap buyer; the party that agrees to receive the floating rate payments and pay the total return is referred to as the total return payeror swap buyer. Total return swaps are viewed as unfunded credit derivatives, because there is no up-front payment required.
If the total return payer owns the underlying asset, it has transferred its economic exposure to the total return receiver. Effectively then, the total return payer has a neutral position that typically will earn LIBOR plus a spread. However, the total return payer has only transferred the economic exposure to the total return receiver; it has not transferred the actual asset. The total return payer must continue to fund the underlying asset at its marginal cost of borrowing or at the opportunity cost of investing elsewhere the capital tied up by the reference assets.
The total return payer may not initially own the reference asset before the swap is transacted. Instead, after the swap is negotiated, the total return payer will purchase the reference asset to hedge its obliga- tions to pay the total return to the total return receiver. In order to pur- chase the reference asset, the total return payer must borrow capital.
This borrowing cost is factored into the floating rate that the total return receiver must pay to the swap seller. Exhibit 5.1 diagrams how a total return credit swap works.
In the exhibit the dealer raises cash from the capital markets at a funding cost of straight LIBOR. The cash that flows into the dealer from the capital markets flows right out again to purchase the reference asset.
The asset provides both interest income and capital gain or loss depend- ing on its price fluctuation. This total return is passed through in its entirety to the investor according to the terms of the total return swap.
The investor, in turn, pays the dealer LIBOR plus a spread to fulfill its obligations under the swap.
EXHIBIT 5.1 Total Return Swaps
From the dealer’s perspective, all of the cash flows in Exhibit 5.1 net out to the spread over LIBOR that the dealer receives from the investor.
Therefore, the dealer’s profit is the spread times the notional amount of the total return swap. Furthermore, the dealer is perfectly hedged. It has no risk position except for the counterparty risk of the investor. Effec- tively, the dealer receives a spread on a riskless position.
In fact, if the dealer already owns the reference asset on its balance sheet, the total return swap may be viewed as a form of credit protection that offers more risk reduction than a credit default swap. A credit default swap has only one purpose: To protect the investor against default risk. If the issuer of the reference asset defaults, the credit default swap provides a payment. However, if the underlying asset declines in value but no default occurs, the credit protection buyer receives no pay- ment. In contrast, under a total return swap, the reference asset owned by the dealer is protected from declines in value. In effect, the investor acts as a “first loss” position for the dealer because any decline in value of the reference asset must be reimbursed by the investor.
The investor, on the other hand, receives the total return on a desired asset in a convenient format. There are several other benefits in using a total return swap as opposed to purchasing a reference asset itself. First, the total return receiver does not have to finance the pur- chase of the reference asset itself. Instead, the total return receiver pays a fee to the total return payer in return for receiving the total return on the reference asset. Second, the investor can take advantage of the dealer’s
“best execution” in acquiring the reference asset. Third, the total return receiver can achieve the same economic exposure to a diversified basket of assets in one swap transaction that would otherwise take several cash market transactions to achieve. In this way a total return swap is much more efficient means for transacting than via the cash market. Finally, an investor who wants to short a credit-risky asset such as a corporate bond will find it difficult to do so in the market. An investor can do so effi- ciently by using a total return swap. In this case the investor will use a total return swap in which it is a total return payer.
There is a drawback of a total return swap if an asset manager employs it to obtain credit protection. In a total return swap, the total return receiver is exposed to both credit risk and interest rate risk. For example, the credit spread can decline (resulting in a favorable price movement for the reference asset), but this gain can be offset by a rise in the level of interest rates. This is the same unfavorable feature of a credit derivative instrument shared by an option on a credit-risky bond described in Chapter 11.
Total Return Swap Compared to an Interest Rate Swap
It is worthwhile comparing market conventions for a total return swap to that of an interest rate swap. A plain vanilla or generic interest rate swap involves the exchange of a fixed-rate payment for a floating-rate payment. A basis swap is a special type of interest rate swap in which both parties exchange floating-rate payments based on a different refer- ence interest rate. For example, one party’s payments may be based on 3- month LIBOR, while the other parties payment is based on the 6-month Treasury rate. In a total return swap, both parties pay a floating rate.
The quotation convention for a generic interest rate swap and a total return swap differ. In a generic interest rate swap, the fixed-rate payer pays a spread to a Treasury security with the same tenor as the swap and the fixed-rate receiver pays the reference rate flat (i.e., no spread or margin). The payment by the fixed-rate receiver (i.e., floating- rate payer) is referred to as the funding leg. For example, suppose an interest rate swap quote for a 5-year, 3-month LIBOR-based swap is 50.
This means that the fixed-rate payer agrees to pay the 5-year Treasury rate that exists at the inception of the swap and the fixed-rate receiver agrees to pay 3-month LIBOR. In contrast, the quote convention for a total return swap is that the total return receiver receives the total return flat and pays the total return payer a interest rate based on a ref- erence rate (typically LIBOR) plus or minus a spread. That is, the fund- ing leg (i.e., what the total return receiver pays includes a spread).
Illustration
Let’s illustrate a total return swap where the reference asset is a corporate bond. Consider an asset manager who believes that the fortunes of XYZ Corporation will improve over the next year so that the company’s credit spread relative to U.S. Treasury securities will decline. The company has issued a 10-year bond at par with a coupon rate of 9% and therefore the yield is 9%. Suppose at the time of issuance, the 10-year Treasury yield is 6.2%. This means that the credit spread is 280 bps and the asset manager believes it will decrease over the year to less than 280 bps.
The asset manager can express this view by entering into a total return swap that matures in one year as a total return receiver with the reference asset being the 10-year, 9% XYZ Corporation’s bond issue.
For simplicity, assume that the total return swap calls for an exchange of payments semiannually. Suppose the terms of the swap are that the total return receiver pays the 6-month Treasury rate plus 160 bps in order to receive the total return on the reference asset. The notional amount for the contract is $10 million.
Suppose that at the end of one year the following occurs:
Total Return Swaps 103
■ The 6-month Treasury rate is 4.8% initially.
■ The 6-month Treasury rate for computing the second semiannual pay- ment is 5.4%.
■ At the end of one year the 9-year Treasury rate is 7.6%.
■ At the end of one year the credit spread for the reference asset is 180 bps.
First let’s look at the payments that must be made by the asset manager.
The first swap payment made by the asset manager is 3.2% (4.8% plus 160 bps divided by two) multiplied by the $10 million notional amount. The second swap payment made is 3.5% (5.4% plus 160 bps divided by two) multiplied by the $10 million notional amount. Thus,
The payments that will be received by the asset manager are the two coupon payments plus the change in the value of the reference asset.
There will be two coupon payments. Since the coupon rate is 9% the amount received for the coupon payments is $900,000.
Finally, the change in the value of the reference asset must be deter- mined. At the end of one year, the reference asset has a maturity of nine years. Since the 9-year Treasury rate is assumed to be 7.6% and the credit spread is assumed to decline from 280 bps to 180 bps, the refer- ence asset will sell to yield 9.4%. The price of a 9%, 9-year bond selling to yield 9.4% is 97.61. Since the par value is $10 million, the price is
$9,761,000. The capital loss is therefore $239,000. The payment to the total return receiver is then:
Netting the swap payment made and the swap payment received, the asset manager must make a payment of $9,000 ($661,000 – $670,000).
Notice that even though the asset manager’s expectations were real- ized (i.e., a decline in the credit spread), the asset manager had to make a net outlay. This illustration highlights one of the disadvantages of a total return swap noted earlier: The return to the investor is dependent on both credit risk (declining or increasing credit spreads) and market risk (declining or increasing market rates). Two types of market interest rate risk can affect the price of a fixed-income asset. Credit independent market risk is the risk that the general level of interest rates will change
First swap payment paid: $10 million × 3.2% = $320,000 Second swap payment paid: $10 million × 3.5% = $350,000
Total payments: $670,000
Coupon payment = $900,000 Capital loss = $239,000 Swap payment = $661,000
over the term of the swap. This type of risk has nothing to do with the credit deterioration of the reference asset. Credit dependent market interest rate risk is the risk that the discount rate applied to the value of an asset will change based on either perceived or actual default risk.
In the illustration, the reference asset was adversely affected by mar- ket interest rate risk, but positively rewarded for accepting credit depen- dent market interest rate risk. To remedy this problem, a total return receiver can customize the total return swap transaction. For example, the asset manager could negotiate to receive the coupon income on the reference asset plus any change in value due to changes in the credit spread. Now the asset manager has expressed a view exclusively on credit risk; credit independent market risk does not affect the swap value. In this case, in addition to the coupon income, the asset manager would receive the difference between the present value of the reference asset at a current spread of 280 bps and the present value of the refer- ence asset at a credit spread of 180 bps.