This example demonstrates the use of leverage in a total return swap. The smaller capital commitment of the total return swap allows the insurance company to earn a higher rate of return on its investment than the outright purchase of the term loan. In fact, the leverage implicit in this total return swap is 10:1. Economically, the total return swap is more efficient because it allows the insurance company to access the returns of the bank loan market with a smaller required investment.
However, what if the value of the term loan had declined at the end of three years? Assume that over the 3-year holding period, the value of the Riverwood International bank loan declined in value to $9 million.
With the total return swap arrangement, the $1 million loss in value would wipe out the posted collateral value. At the end of year three, the insurance company would receive only the cash flow from the interest income, $225,000 from the swap, and $60,000 in interest from the posted collateral.
Under the purchase scenario, the insurance company would receive back $9 million of its committed capital. Additionally, in each year the insurance company would receive the $950,000 interest income from the term loan. Exhibit 5.2 also compares the two investment choices under the assumption of a $1 million decline in loan value.
Under the total return swap, the net present value of the investment is now a negative $236,868. Conversely, a decline in loan value of $1 million still leaves the purchase scenario with a positive net present value of $120,431. Comparing the IRR on the two investments, we now see that the total return swap yields a negative IRR of –7%, while the purchase of the term loan yields a positive IRR of 6%—slightly more than the insurance company’s cost of borrowed funds. Exhibit 5.2 dem- onstrates that the embedded leverage in the total return swap can be a double-edged sword. It can lead to large returns on capital, but can also result in rapid losses.
at one time referred to as the corporate sector), the mortgage sector (con- sisting of agency residential mortgage-backed securities), the commercial mortgage-backed securities (CMBS) sector, and the asset-backed securi- ties (ABS) sector. The non-Treasury sectors offer a spread to Treasuries and are hence referred to as “spread sectors.” The spread in the mort- gage sector is primarily compensation for the prepayment risk associated with investing in this sector. Spread to compensate for credit risk is offered in the credit spread sector, of course, and the CMBS and ABS sec- tors. There are also indexes available for other credit spread sectors of the bond market: high-yield corporate bond sector and emerging market bond sector. Thus, a total return index swap in which the underlying index is a credit spread sector allows an asset manager to gain or reduce exposure to that sector.
We conclude this chapter with a discussion of the flexibility offered asset managers and hedge fund managers by using total return swaps in which the index is a credit spread sector of the bond market.
Indexing a Credit Spread Sector by an Active Asset Manager
Bond portfolio strategies range from indexing to aggressive active strat- egies. The degree of active management can be quantified in terms of how much an asset manager deviates from the primary risk factors of the target index. A bond indexing strategy for a sector involves creating a portfolio so as to replicate the issues comprising the target sector’s index. This means that the indexed portfolio is a mirror image of the target sector index or, put another way, that the ex ante tracking error is close to zero.
Why would an asset manager pursuing an active portfolio manage- ment strategy want to engage in an indexing strategy for a credit sector of the target index? Suppose that the asset manager’s target index is the Lehman Brothers U.S. Aggregate Bond Index. Suppose further that the asset manager skills are such that she believes she can add value in the mortgage, CMBS, and ABS sectors but has no comparative advantage in the credit (corporate sector). The asset manager in this case can under- weight the credit sector. However, the risk is that the credit sector will perform better than the other sectors in the target index and, as a result, the asset manager will underperform the target index. An alternative is to be neutral with respect to the credit sector and make active bets within the sectors of the target index that the asset manager believes value can be added. This approach requires that the asset manager follow an index- ing strategy for the credit sector of the target index. However, in pursu- ing this strategy of creating a portfolio to replicate the credit sector, the asset manager will encounter several logistical problems.
First, the prices for each issue in the credit sector used by the orga- nization that publishes the sector index may not be execution prices available to the asset manager. In fact, they may be materially different from the prices offered by some dealers. In addition, the prices used by organizations reporting the value of sector indexes are based on bid prices. Dealer ask prices, however, are the ones that the manager would have to transact at when constructing or rebalancing the indexed port- folio. Thus there will be a bias between the performance of the sector index and a portfolio that attempts to replicate the sector index that is equal to the bid-ask spread.
Furthermore, there are logistical problems unique to certain sectors in the bond market. For the credit sector, which consists of investment- grade corporate bonds, there are typically more than 4,000 issues.
Because of the illiquidity for many of the issues, not only may the prices used by the organization that publishes the index be unreliable, but also many of the issues may not even be available.
Third, as bonds mature, their shrinking duration will force them out of this index. This will create natural turnover and higher transaction costs.
Last, bonds pay consistent coupons that must be reinvested in the index.
In the absence of a total return swap, there are two methodologies that have been used to construct a portfolio to replicate the index repre- senting the credit sector: stratified sampling methodology and the vari- ance minimization methodology. With the stratified sampling approach (or also called the cellular approach) to indexing, the sector index is divided into cells representing the primary risk factors. The objective is then to select from all of the issues in the index one or more issues in each cell that can be used to represent that entire cell. The total dollar amount purchased of the issues from each cell will be based on the per- centage of the index’s total market value that the cell represents. For example, if X% of the market value of all the issues in the credit sector index is made up of single-A rated corporate bonds, then X% of the market value of the replicating portfolio should be composed of single- A rated corporate bond issues. The number of cells that the asset man- ager uses will depend on the dollar amount of the portfolio to be indexed. In indexing a portfolio of less than $50 million, for example, using a large number of cells would require purchasing odd lots of issues. This increases the cost of buying the issues to represent a cell, and thus would increase the ex ante tracking error. Reducing the num- ber of cells to overcome this problem increases ex ante tracking error because the major risk factors of the indexed portfolio may differ mate- rially from those of the index. For corporate bonds, for example, there is the concern of downgrade risk of individual corporate issues that would adversely affect tracking error. Exhibit 5.3 shows the findings of
a Lehman Brothers study that demonstrates how many issues must be purchased to minimize tracking error due to downgrade risk.2As can be seen, if only a few issues are selected tracking error is high.
The variance minimization methodology is a more complicated approach than stratified sampling. This approach requires using histori- cal data to estimate the variance of the tracking error for each issue in the index. The objective then is to minimize the variance of the tracking error in constructing the replicating portfolio.
The more efficient solution may be simply to use an total return index swap where the credit sector to be indexed is the underlying index for the swap.
Active Strategies
Active bond portfolio strategies involve constructing a portfolio that deviates from the target index. There are various strategies that can be employed. For example, one strategy is to construct a portfolio that is intentionally different from the duration of the target index based on the view of the asset manager regarding future interest rates. Another is to overweight a sector of the index based on the asset manager’s view of
2Lev Dynkin, Jay Hyman, and Vadim Konstantinovsky, “Sufficient Diversification in Credit Portfolios,” Journal of Portfolio Management (Fall 2002), pp. 89–114.
EXHIBIT 5.3 Risk due to Downgrades as a Function of Portfolio Size—by Credit Quality
Source:Exhibit 14 in Lev Dynkin, Jay Hyman, and Vadim Konstantinovsky, “Suf- ficient Diversification in Credit Portfolios,” Journal of Portfolio Management(Fall 2002), p. 100.
the relative performance of the sectors comprising the index. For exam- ple, if the credit sector is expected to outperform the other sectors, an asset manager may wish to overweight that sector. The asset manager can monetize this view by entering into a total return swap as the total return receiver. Again, as noted earlier, this is an efficient way to repli- cate the performance of the index.
Hedge funds manager can use total return swaps to create leverage in the same way described earlier when we showed how a synthetic repo can be created for a credit-risky bond. Moreover, suppose instead that a hedge fund manager believes that the credit sector will have a negative return. The manager can monetize this view by selling a total return swap. The advantage of the total return swap is that the credit sector can be shorted, a task that is extremely difficult and costly to do for individual bond issues in the credit sector.
Risk Control
Total return swaps can be sued as effective risk control instruments.
Interest rate swaps can be used to control the duration of the portfolio.
Total return swaps can be used to control the spread duration of a port- folio and, more specifically, the credit spread duration of a portfolio, that is the sensitivity of a portfolio to changes in credit spreads. Hedg- ing a position with respect to credit spread risk means creating a cash and total return swap position whereby the credit spread duration is zero. An asset manager would want to hedge a portfolio that has expo- sure to credit spread risk if the credit spread duration of the portfolio differs from that of the target index. Total return swaps can be used to bring the portfolio’s credit spread risk duration in line with the credit spread risk of the target index.