Total Return Swaps have been gaining steam in recent years and their popularity is expected to grow as hedge funds continue to drive volume, the European market heats up and the structure is applied to products other than leveraged loans. Chris Hentemann, managing director and co-head of global structured finance at Bank of America, estimates about 20% growth, year on year, for TRS. "The current growth rates of TRS are a product of a benign credit environment, increased use of the product and expansion into alternative credit products," he said.
It is difficult to say how many TRS deals are done a year. Citigroup did approximately 25 swaps in 2005, for several billion dollars and Deutsche Bank generally does about eight-10 a year in the United States. Barclays Capital estimates the market size is about $75 billion in total and there may be as many as 100 different manager groups and probably about 200 counterparties. Philip Nisbet, director and senior structured trader at Barclays, estimated that a larger bank could be doing transactions of about $3 billion to $7 billion a year.
In a typical TRS, one party agrees to pay the total return of an asset to a counterparty in exchange for a floating interest rate and a guaranteed spread. The purchaser of the swap usually bears all the credit, interest rate and market risk, but they also stand to gain a solid return at a fraction of the upfront cost. Flexibility is one of the main reasons why hedge funds have been active in the market. "It allows them to carve out an allocation of their fund and invest in the loan market," said Steve Snizek, director and trader at Deutsche Bank.
Investors are increasingly using TRS to run the credit spectrum and take bigger bets, especially in distressed names, than they might have in a CLO. "Investors look at TRS as an alternative means for gaining access to credit exposure as opposed to buying cash credit," said Hentemann.
But juiced up returns remain the biggest driver. With money on the sidelines waiting to be deployed and a paucity of paper, TRS offers a way to get leveraged exposure to credit. Barclays' Nesbit expects hedge funds to become even more active. "If they need 15% returns, you can't get that unless you have leverage," he said. Snizek agreed. "The leverage the Total Return Swap provides allows them the ability to achieve an overall higher return."
Another reason TRS volume is expected to be high is activity overseas. Deutsche Bank has recently expanded its coverage into Europe, doing Europe-only TRS and signed two European TRS in June. "As our U.S. counterparties started buying European loans, we liaisoned with our London desk, haircutted the loans appropriately and we were able to offer financing," said John Gally, who works on the product at Deutsche Bank. "We saw liquidity improve in Europe so we went over there and marketed the product and have signed a couple of European-only funds, European hedge fund clients." He estimated that about 15% of Deutsche Bank's book is in non-U.S. denominated loans, but that was with U.S. hedge funds. The bank now has European funds with European-only loans.
Citigroup has had an established desk in Europe for the past few years. "I think it is important because a lot of U.S. investors see value in Europe," said Mitali Sohoni, director in credit derivatives at Citigroup and head of portfolio Total Return Swaps. "But the bulk of U.S. investors still focus primarily on U.S. assets." Barclays also has a European TRS group and Bank of America first opened up an operation in London a year ago. "We started to see an increase in some of our loan manager activity in Europe and decided to build a TRS business alongside of our leveraged loan platform," said Hentemann.
The product may also grow as banks apply it to other asset classes. "I think the [use of the product] will continue to expand; it is possible the market will move into using TRS as a means to go long and short in the asset class," said Citi's Sohoni. The bank is already using TRS embedded in CDOs and on bonds but is also exploring doing them on ABS and tranches of CDOs.
Hentemann said TRS could be used with real estate loans, CMBS and some ABS products, as well as corporate loans. He estimates that TRS used in combination with structured-credit assets are currently about 80% leveraged loans and about 20% other asset classes.
Nesbit said a dislocation in the market or widening of spreads could slow things down in the U.S., but he expects growth to continue. Anthony LoGrippo, managing director at Deutsche Bank, is also optimistic about the future of the product. "Now that this market has established itself as being liquid, we can expect a lot of the strong crossover guys to stay, continue to trade throughout the capital structure and look for relative value. I think [the growth of the product] is going to continue in step with the leveraged loan market."