A Total Return Swap (TRS) is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets in exchange for periodic cash flows, typically a floating rate such as LIBOR +/- a basis point spread and a guarantee against any capital losses.  A TRS is similar to a plain vanilla swap except the deal is structured such that the total return (cash flows plus capital appreciation/depreciation) is exchanged, rather than just the cash flows.

A key feature of a TRS is that the parties do not transfer actual ownership of the assets, as occurs in a repo transaction.  This allows greater flexibility and reduced up-front capital to execute a valuable trade.  This also means Total Return Swaps can be more highly leveraged, making them a favorite of hedge funds. 

Total Return Swaps (TRS) are also known as Total Rate of Return Swaps (TROR). 

Market Participants

The Total Return Swap market is strictly institutional over the counter (OTC).  Market participants include investment banks (Goldman Sachs, JPMorganChase), commercial banks (Bank of America, Sumitomo), mutual funds (Prudential, Merrill Lynch Asset Management), hedge funds, funds of funds, private equity funds, pension funds (CalPers), university endowments (Harvard, University of California), credit card lenders (American Express, MBNA/Bank of America), insurance companies (AIG, State Farm), governments, non-governmental (NGO) organizations (World Bank, Inter-American Development Bank), home loan banks (FHLB, Fannie Mae, Freddie Mac), and the Treasury departments of large multinational corporations (Wal-Mart, British Petroleum).  A variety of special purpose vehicles (SPVs) such as CDOs and real estate investment trusts (REITs) also participate in the TRS market.

The TRS market was traditionally between commercial banks where one party (Bank A) had exceeded its balance sheet limits, and the other (Bank B) had balance sheet capacity available.  Bank A could shift assets off its balance sheet synthetically and gain additional income with less risk.  Bank B could "lease" the assets of Bank A by paying some regular cash flows and offering a guarantee against any capital losses.

In the last 10 years, hedge funds and special purpose vehicles have become a major force in the TRS market.  Now the most common use of a TRS is for "leveraged balance sheet arbitrage", whereby a hedge fund lacking a large balance sheet and seeking leveraged exposure to particular assets pays for that exposure by "leasing" the assets from a major bank, mutual fund, or securities dealer.  The hedge fund hopes to generate high asset returns without having to tie up its capital by buying those assets for its own account.  The bank, fund, or dealer hopes to generate additional cash flow by charging a spread over and above the market returns it receives from lending or other activities, and receiving a guarantee against depreciation of the assets. 

A TRS can be structured on any type of reference asset, including single equities, indexes, leases, oil-backed credit obligations, baskets of corporate bonds, mortgages, municipal bonds, other swaps or derivatives, real property, credit card ABS, residential MBS, CDO notes, investment grade convertible bonds, etc.  This makes the range of potential market participants extremely broad.

TRS Transaction Structure

A TRS is made up of two legs, the Return Leg (or Total Return Leg) and the Funding Leg.  The reference asset or basket of assets exists on the Return Leg. The cash flow payment stream exists on the Funding Leg. 

The Return Leg is generally made up of two components: cash flows and capital appreciation of the reference asset(s).  The Funding Leg also has two components: floating coupons based on LIBOR +/- a spread and payments to offset any capital depreciation of the reference asset(s).

Additional legs may be structured to account for reinvestment of returns, interest payments on collateral / haircuts, multi-currency flows, or differing payment schedules.  Fees, spreads, principal payments, etc. may be added in a customized structure.

The Return Leg counterparty is called the Total Return Payer, Swap Seller, Buyer of protection, or Beneficiary.  Here, we will use the term Total Return Payer or TRP.  The TRP (typically a bank, fund, or dealer) has a long position in the reference asset or basket of assets, holding them on its balance sheet.  The TRP "buys protection" on these asset returns by agreeing to pay all of the future returns of the reference asset(s) in exchange for a floating stream of payments, usually LIBOR +/- a spread, plus a guaranteed offset of any capital losses incurred by the reference asset(s). The TRP gives up one set of expected future returns (capital appreciation, coupons, fees, dividends, etc.) in exchange for another set of future returns (LIBOR coupons +/- a spread) and capital loss insurance.  This allows the TRP to lock in the value of its asset(s) and receive additional income.

CONTINUED IN PART 2 >>