Total Return Swaps are also very common in many structured financial transactions, such as secured bonds (guaranteed bonds (CDOs). LCO issuers often enter into TRS agreements as protection sellers to use the yields for the structure`s debts. By selling the protection, CDO commits to the underlying assets without having to raise capital to acquire the assets directly. The LCO receives interest on the benchmark during the period, while the counterparty reduces its credit risk. Less common but related are the partial return swap and partial returns of reverse exchange agreements, which usually include 50% of the return or another amount indicated. Reverse swaps include selling the asset with the seller and then buying returns, usually on the shares. I have attended presentations where these are the only reasons to motivate the overall return recipient. The above reasons are often true. But it`s like saying why you drive a Porsche Targa around a circuit, it takes you faster than on foot. That`s true, but that`s not what you`re doing. The main reason that overall return recipients enter into this transaction is to use leverage. Investors do not make upfront cash payments. Cash flows are generally paid net.
Investor “payments” are deducted in advance from the cash flow of the securities. The investor does nothing but receive a positive net payment. (This assumes that the investor`s financing costs remain lower than the cash flow generated by the security. If the investor receives a fixed coupon and makes a variable payment, in a reverse yield curve environment, the investor may be able to make a net payment.) Leverage is the reason hedge funds are a primary objective as counterparties in TRS. Hedge funds are the beneficiary of the overall return. The main reason for hedge funds is the use of leverage. The participation of hedge funds and other fragile loans, although partially guaranteed, is a critical and not necessarily welcome development in the credit derivatives market. While the reason for the hedge fund counterparty is leverage, the payor`s reason for the overall interest return in the TRS is to declare high profits.
We will take a closer look at this transaction and the quality of these profits in the hedge fund section.