An asset’s total return measures how much value it generates in total. This includes both capital gains (when an asset gains market value) and income (when an asset makes a direct payment). Total return is one measure of an asset’s value to an investor. It’s led to the total return swap.
What are Total Return Swaps?
A total return swap is an contract where one party makes a series of set payments and, in return, they receive the total return of an asset held by the other party. This includes all income payments and either the debits or credits from any final capital gains. This is structured as a contract with a series of payments and a fixed end date. Also, it’s usually built around securities such as stocks, funds, or bonds and other forms of credit.
This is, effectively, a way to rent securities. It lets one party receive all the benefits of owning a security without having to lock up funds in that asset.
Total return swaps are a form of derivative product. As a result, the contract takes its value from the value of an underlying asset. In this case the underlying asset is the security at the heart of the contract.
The parties in a total return swap are generally referred to as the Receiver and the Payer. The Receiver gets the total return of the asset. The Payer settles the total return of the asset. This can get confusing. Both parties make payments to each other, and both receive payments from each other.
How Does a Total Return Swap Work?
Think of a total return swap like renting a home.
Say you would like to live in a home but don’t want to make a down payment. To solve this problem, you find someone who already owns the home but who doesn’t need its benefits (a landlord). You arrange to make a series of fixed payments (rent). In return, you receive all the benefits of this property (a place to live) without having to make the initial financial commitment. A total return swap works much the same way.
Two parties, an owner and a renter, enter a contract. The renter agrees to make regular financing payments to the owner. These can be either fixed or fluctuating, depending on the terms of the contract.
In exchange, the owner pays to the renter the total return on a specific asset or bundle of assets. This includes:
- Income: Over the lifetime of the contract, the owner pays the renter any income generated by the assets.
- Capital Gains: At the end of the contract the owner compares the final price of the asset with its price at the beginning of the contract. If the asset has appreciated in value, the owner pays the renter the difference in value. If the asset has depreciated, the renter pays the owner the difference.
The renter receives all the value of the underlying asset but ownership never actually transfers.
Total Return Swap Risks
A total returns swap is particularly useful to investors looking for large amounts of exposure. For example, funds often use this form of contract. This gives them access to the volume they need (as mutual funds and ETFs need to invest in very large quantities to meet the size of their investor base) without comparably large up-front capital expenses.
The parties in a total return swap are, ultimately, exchanging risks:
- The receiver assumes any systematic and unsystematic risk of the underlying asset. If the asset loses value, the receiver will make payments based on those losses. In exchange, they receive any potential yield and return generated by this asset.
- The payer loses the risk associated with this asset and receives set payments. In exchange, however, they risk any potential income generated by this asset as well as the potential for all capital gains.
Total Return Swaps In Action
Consider two parties. Receiver would like to invest in ABC Co., but he doesn’t have the cash on hand to make a large investment. Payer holds considerable shares in ABC Co., but would like to secure a more stable cash flow. They reach the following arrangement:
- Receiver will pay to Payer $50 per month for the next five years. This is the financing charge for accessing the stock’s total return.
- Payer will pay to Receiver the total return of 1,000 shares of ABC Co. stock for the next five years.
At the time of their arrangement, ABC Co. stock sells for $5 per share.
The following year, ABC Co. issues a dividend of $1 per share. When Payer receives his dividend payments, he issues a payment of $1,000 to Receiver ($1 per share for the 1,000 shares involved in this total return swap).
Total Return Swap Results
At the end of five years, ABC Co. has increased to $8 per share. Payer will issue Receiver a payment for $3,000 (reflecting the $3 per share increase for the 1,000 shares involved in this total return swap). Receiver has paid a total of $3,000 for this deal and received $4,000 in capital gains and income.
Say, however, that at the end of five years ABC Co. has fallen to $4 per share. Receiver will now issue to Payer a payment of $1,000 (reflecting the $1 per share decrease for the 1,000 shares involved in this total return swap). Receiver will now have paid a total of $4,000 for this deal and received $1,000 of income payments.
Note that this is a simplified example. In practice, investors tend to build total return swaps around index values. However, in real life, Receiver would likely structure his payments around a common financial benchmark such as the prime rate or the LIBOR. In return, payer would likely make payments based on an index such as the S&P 500 or a bond index.
Bond Index Total Return Swaps
Bonds have become one of the most popular underlying assets for total return swaps.
A bond index total return swap is a contract in which the total return swap is indexed to a series of bonds. This is a particularly good structure compared to something like an equity. Among other reasons:
- The total return contract will issue guaranteed income payments based on the underlying bonds’ coupon payments.
- The risk of capital loss is limited in a bond. For bonds with good credit rating, the final risk is largely systemic and based on demand in the market for bonds in general. (Note that this should not be confused with no risk. If the sale price of bonds goes down over the course of the contract, a bond indexed total return swap can still lose money.)
- It allows the investor to access a bond market without having to buy and sell bonds, which are capital-intensive, long term instruments.
Why Do Payers Enter a Total Return Swap?
As discussed above, the main reason for receivers to enter a total return swap is leverage. It allows them to access large investments without having to stake large amounts of up-front capital.
For payers, the benefits are somewhat more nuanced. In most cases the payer in a total return swap is looking for two things:
- Stability and Income – A total return swap allows the payer to exchange any potential speculative gains of an underlying asset for stable, known payments. This can also allow them to begin generating immediate income instead of having to wait for eventual capital gains. For many payers, payments today may have more value than capital gains in several years.
- Risk Mitigation and Short Positions – Many payers use total return swaps to mitigate the risk of a position. It creates a risk profile similar to taking a short position on an asset, since the payer will receive a payment if the asset’s value decreases. As a result, this can allow the payer to diversify their portfolio, mitigate the risk of a long position, or even take a short position outright.
The Bottom Line
A total return swap is when two parties enter into a contract to effectively lease out the value of an investment. In this contract, the payer will pay out the total return of specified investment asset, including all income and capital gains. In exchange the receiver, who receives the total return on the asset, will make set payments.
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- There’s more to investing than just objective rates of return. Time rate of return, for example, can help you look at your portfolio in terms of deposits and withdrawals.
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