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Total Return Swap (TRS) PART 3


Total Return Swap Examples

In a Bank Loan TRS, a large bank such as Barclays (the Total Return Payer) purchases a loan.  It then enters into a TRS with an investor (the Total Return Receiver).  The bank pays all the interest and realized capital gains to the Seller, minus a "funding charge" (akin to an access fee to the bank's balance sheet). The investor pays LIBOR plus a spread, plus any realized capital losses to the bank.  Initial collateral (the "haircut" or "Independent Amount" in swap language) of between 15% and 80% is paid to the bank by the investor at the inception of the TRS.  The bank holds this collateral in a separate account and pays the investor periodic interest at the Fed Funds Effective Rate.  Collateral treatment is typically "full recourse", meaning the investor must post additional collateral if the asset value drops, or may withdraw collateral if the asset value increases. The reference assets (loans) are periodically marked to market using LoanX, LPC, or dealer quotes. A Bank Loan TRS can be executed on a single loan (typical trade size US$5-10MM, up to $50MM) or a portfolio of loans (typical trade size US$250-750MM, up to $1B+).  In both cases, a TRS is more flexible than buying a loan or investing in a Collaterized Loan Obligation (CLO).  If the TRS is based on a portfolio of loans, the investor must maintain a set of portfolio criteria for the life of the TRS, consisting of percentage of senior secured vs. unsecured/high yield bonds, maximum obligor exposure, maximum industry exposure, minimum rating, and average portfolio rating.  A Bank Loan TRS can be structured on a variety of loans, including par term and revolving loans, second lien loans, stressed and distressed loans, middle market and direct financing loans, high yield bonds, and international loans. 

In a Capital Structure Arbitrage TRS a hedge fund (Total Return Receiver) focused on fixed income will use a TRS to synthetically "purchase" a basket of debt from a bank (Total Return Payer) on leverage, gaining exposure to a particular market segment such as mid-size private industrial company loans.  The fund may then take a short position in similar risky unsecured bonds, or purchase credit default swaps (CDS) on similar companies to shift away default risk.  The goal may be to create a "positive carry" situation where post-deal cash flows to the investor are higher than those paid to the bank.  Alternatively, the hedge fund may anticipate the spread between high-grade and low-grade bonds will widen if the overall credit environment deteriorates, thereby gaining more on the drop in unsecured debt than the drop in secured debt.

In a Moderate Leverage Par TRS a leveraged loan fund (Total Return Receiver) uses a TRS to synthetically "purchase" a portfolio of debt form a bank (Total Return Payer), with a 4x-5x target leverage.  This allows the fund to increase yields, with a target of 1%-1.5% of consistent returns per month.  The fund will typically diversify broadly and engage in various derivatives arrangements to reduce portfolio risk while generating high yields.

In a High Leverage Par TRS a leveraged loan fund (Total Return Receiver) uses a TRS to synthetically "purchase" debt from a bank (Total Return Payer) with a 10x target leverage.  The fund buys only the highest quality debt, diversifies broadly, and engages in various derivatives arrangements to reduce portfolio risk while generating high yields of 15-20% per year.

In a Distressed Debt TRS a hedge fund (Total Return Receiver) uses a TRS to synthetically acquire exposure to high yield or underperforming loans with the hope that the obligors will return to normal payment patterns.  As the loan quality increases, so does the mark-to-market value and cash flows, creating the potential for both high capital gains and growing cash flows.  Since the loans are purchased in distressed state, the downside may be limited for the investor, and the bank (Total Return Payer) is happy to generate more reliable cash flows and protect against total loss in the event of bankruptcy of the obligors.

In a Commercial Mortgage-Backed Securities (CMBS) TRS an asset manager (Total Return Receiver) seeking exposure to the mortgage market enters into a TRS with a mortgage dealer or lender (Total Return Payer).  The reference asset may be the Lehman Aggregate CMBS Index, Bank of America CMBS Index, the NCREIF Property Index (private commercial real esate), 144A private transaction mortgages, unique mortgage portfolios or baskets, or a single large commercial or industrial mortgage.  The asset manager hopes the mortgage market or a segment thereof will rise faster than floating rates, thereby gaining on the higher growth of asset value above the lower growth of financing rates.

In a Commodity Index TRS the investor (Total Return Receiver) pays a money market rate plus fees to a counterparty (Total Return Payer) in exchange for the total return of a specified commodity index such as the Dow Jones-AIG Commodity Index or Goldman Sachs GSCI Commodity Index.

In a Temporary Negative View TRS the Total Return Payer has a long term position in an asset, but believes that its value will decrease for a period of time and wants to protect against that drop in value.  The Total Return Payer enters into a TRS with a counterparty who has the opposite opinion.  The duration of the TRS is shorter than the intended holding period of the asset, allowing the Total Return Payer to maintain its long term position but achieve protection against its drop in value and potentially earn additional returns in the near term.

In a Synthetic Repo TRS the parties actually transfer ownership of the reference asset(s) from the initial owner (Total Return Payer) to the investor (Total Return Receiver), like a repo transaction.  A Synthetic Repo TRS may occur in a single transaction or multiple transactions, for example a repo plus a related swap agreement.  This may be done where the investor requires certain benefits of ownership, such as preferred stock voting rights or dividend receipts, or where the asset owner needs to get illiquid assets off its books quickly but the investor does not want to service them or deal with transfer costs.  The investor never takes possession of the asset(s), leaving them under the control of the original owner, who agrees to provide ongoing asset management.  Other potential reasons for a Synthetic Repo TRS include regulatory or tax arbitrage, cross-border asset transfer limitations, or simply limited time to execute a trade. 

Other TRS Examples
- Airplane Lease TRS
- High Yield Bond Basket TRS
- Dividend-Paying Equity Portfolio TRS
- Insurance Policy TRS


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