Total Return Swaps (TRS) are swap contracts where one counterparty pays/receives the total return of an asset to/from another counterparty, versus receiving/paying a “financing” rate. Bond Index Total Return Swaps are especially gaining traction with bond and credit portfolio managers as an effective tool for hedging and adding risk rapidly to generate alpha.
With swap contracts, the Financing Rate is effectively meant to compensate the index payer for enabling the index receiver to not tie up funds in a physical bond or loan (typically set to LIBOR in the relevant currency). The Index Receiver always pays the Financing Rate to the Index Payer.
The Index Total Return is the percentage change in value of the reference index from when the contract was entered to when the contract was exited, by either trading out of the contract or waiting until the swap maturity date.
If the Index Total Return is positive, then the Index Payer makes a payment to the Index Receiver. If the Index Total Return is negative, then the Index Receiver makes a payment to the Index Payer.
Standardization
TRS contracts are customizable. They can reference any index and have maturities and payment dates that match a company’s specific needs. Liquidity, however, is becoming concentrated in the most relevant indices with standard terms. This standardization is occurring in the following ways:
- Only a small subset of all bond indices is being referenced in contracts. Contracts referencing the most relevant benchmark indices are attracting the most interest. These benchmarks where liquidity is best include aggregate, high yield, emerging markets, leveraged loan and investment grade.
- Indices that are well-supported in terms of their construction and daily valuations are also critical to the success of a TRS contract. The better the underlying index is maintained and priced, the less risk that the index itself might not perform in line with the market it represents.
- The maturity and payment frequency and Financing Rate are also being standardized.
- As more contracts are traded with the same terms, liquidity improves for managers who do not want to hold the contract until the scheduled swap maturity date.
- Bloomberg Total Return Swaps (BTRS) offer further standardization in contract terms. Additional contract term standardization makes it easier for investors to efficiently manager their risk and counterparty exposure as BTRS contracts are more fungible than standard TRS contracts. A full suite of analytics and trading tools, such as straight through processing (STP), including automatic VCON generation has been implemented by Bloomberg, making the mechanics of trading and managing risk easier.
The Index Total Return
When a trade is entered into, the buyer and seller agree to an initial index value. This traded index value will be linked to the index value, but will deviate based on supply and demand amongs other factors. The Financing Rate is also set. Depending on the contract entered into, there may be an initial exchange of cash and initial margins.
If a contract is held to the swap maturity date, the value that will be used for the index is the published value of the index. A payment will be made from one party to the other depending on the terms of the trade; however, it is important to remember that if the total return is positive, that leg will be paid by the payer to the receiver — vice versa if it is negative.
If a contract is unwound by trading out of it early, the buyer and seller agree to the index value at the time of trade — just like when the TRS was initially entered into. The negotiated or traded price is used to determine final payment.
The Traded Index Value versus the Calculated Index Value
Multiple factors determine the negotiated index value:
- The calculated index value is the biggest driver.
- Supply and demand on the contract. If more people are looking to hedge, then the price will have to be adjusted to attract those looking to receive.
- Borrowing or shorting costs in the underlying markets will impact the price that is agreed to. If it is expensive to short bonds that cost will affect the price that the contract is entered into, since the financing leg, which would otherwise be adjusted, is fixed to permit standardized valuation.
- Any perception of a lag in the calculated index value, which may occur in volatile markets, would cause the traded price to deviate from the calculated price. This is mitigated to a large degree by only referencing indices from well-known providers, such as Bloomberg.
Total Return Swaps — Simple, but effective
As investors explore ways to manage bond and credit risk effectively and efficiently, look for them to turn more and more to total return swaps. A number of broad market indices can be traded in standardized TRS and BTRS forms, volumes are increasing and liquidity is improving; accordingly, asset managers, large and small, must understand these products and determine if they are suitable for their investment strategies.