A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.

The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.

Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates.

A portfolio manager typically uses a total return swap to increase exposure to a reference obligation, in contrast to a credit default swap, which is described later, that is used to hedge a credit exposure. A total return swap transfers all of the economic exposure of a reference obligation or reference obligations to the total return receiver. In return for receiving this exposure, the total return receiver pays a floating or fixed rate to the total return payer.

FundsAs an example of a total return swap, consider a portfolio manager who believes that the fortunes of Izzobaf Corporation will improve over the next year, and that the company’s credit spread relative to U.S. Treasury securities will decline. The company has issued a 10-year bond at par with a coupon rate of 9% and therefore the yield is 9%. Suppose that at the time of issuance the 10-year Treasury yield is 6.2°/o. This means that the credit spread is 280 basis points and the portfolio manager believes it will decrease over the year to less than 280 basis points.

The portfolio manager can express this view by entering into a total return swap that matures in one year as a total return receiver with the reference obligation being the 10-year, 9% Izzobaf Corporate bond issue. For simplicity, assume that the swap calls for an exchange of payments semiannually. Suppose the terms of the swap are that the total return receiver pays the six-month Treasury rate plus 160 basis points in order to receive the total return on the reference obligation. The notional amount for the contract is $10 million.

Suppose that over the one year, the following occurs:

First let’s look at the payments that must be made by the portfolio manager. The first swap payment made by the portfolio manager is 3.2% (4.8% plus 160 basis points divided by 2) multiplied by the $10 million notional amount. The second swap payment made is 3.5% (5.4% plus 160 basis points divided by 2) multiplied by the $10 million notional amount. Thus

First swap payment: $10 million x 3.2% = $320,000

Second swap payment: $10 million x 3.5% = $350,000

Total payments = $670,000

The payments that will be received by the portfolio manager are the coupon payments plus the change in the value of the reference obligation. There will be two coupon payments. Since the coupon rate is 9% the amount received for the coupon payments is $900,000.

Finally, the change in the value of the reference obligation must be determined. At the end of one year, the reference obligation has a maturity of 9 years. Since the 9-year Treasury rate is assumed to be 7.6% and the credit spread is assumed to decline from 280 basis points to 180 basis points, the reference obligation will sell to yield 9.4%.The price of a 9%, 9-year bond selling to yield 9.4% is 97.61. Since the par value is $10 million, the price is $9,761,000. The capital loss is therefore $239,000. The payment to the total return receiver is then

Coupon payment =

$900,000
Capital loss =

$239,000
Swap payment =

$661,000

Netting the swap payment made and the swap payment received, the portfolio manager must make a payment of $9,000.

Notice that even though the portfolio manager’s expectations were realized (i.e., a decline in the credit spread), the portfolio manager had to make a net outlay. This illustration highlights one of the disadvantages of a total return swap: The return to the investor is dependent on both credit risk (declining or increasing credit spreads) and market risk (declining or increasing market rates). Two types of market interest-rate risk can affect the price of a fixed-income asset. Credit-independent market risk is the risk that the general level of interest rates will change over the term of the swap. This type of risk has nothing to do with the credit deterioration of the reference obligation. Credit-dependent market interest-rate risk is the risk that the discount rate applied to the value of an asset will change based on either perceived or actual default risk.

In the illustration, the reference obligation was adversely affected by market interest-rate risk, but positively rewarded for accepting credit-dependent market interest-rate risk. To remedy this problem, a total return receiver can customize the total return swap transaction. For example, the portfolio manager could negotiate to receive the coupon income on the reference obligation plus any change in value due to changes in the credit spread. Now the portfolio manager has expressed a view exclusively on credit risk; credit-independent market risk does not affect the swap value. In this case, in addition to the coupon income, the portfolio manager would receive the difference between the present value of the reference obligation at a current spread of 280 basis points and the present value of the reference obligation at a credit spread of 180 basis points.

Benefits of Total Return Swaps

There are several benefits in using a total return swap as opposed to purchasing reference obligations themselves. First, the total return receiver does not have to finance the purchase of the reference assets. Instead, it pays a fee to the total return payer in return for receiving the total return on the reference obligations.

Second, the total return receiver can achieve the same economic exposure to a diversified basket of assets in one swap transaction that would otherwise take several cash market transactions to achieve. In this way a total return swap is a much more efficient means for transacting than the cash market.

Finally, an investor who wants to short the corporate bond will find it difficult to do so in the corporate bond market. An investor can do so efficiently by using a total return swap. In this case the investor will use a total return swap in which it is a total return payer and will receive a floating payment.

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