In the wake of the financial crisis, pension funds all over Europe have been struggling with below-par funding ratios and the resultant simultaneous need to take on more risk while shelling out less of their balance sheet.
A total return swap (TRS) is one way of getting that exposure without the initial capital outlays (see box, page 14). The return on some given reference asset – coupons, dividends and mark-to-market changes – is swapped in exchange for a floating rate, usually a spread above or below Libor, depending on the underlying.
The structure has numerous advantages: the return is directly in the contract, so there is no basis risk or worrying about the structure of hedging assets; it allows less nuanced investors to use the expertise in the broking market; there are collateral advantages over other synthetics such as futures; and there is even the possibility that the product could replace the back-office staff who traditionally source the physical assets for a hedging portfolio.
But investors have had their fingers burnt before by financial innovation. This year’s hot product can end up on history’s scrap heap, or worse: witness the mortgage-backed securities and collateralised debt obligations that were the agents of contagion in the crisis. The complexity – or at any rate the extent to which a product is understood in the marketplace – will always have a bearing on how liquid it will remain in troubled times.
The attraction of these synthetic instruments is driven by two main factors: the premium for holding cash at a time of tight liquidity (so-called ‘balance sheet rent’ – see Life & Pension Risk, May 2010, page 20), and a need to ramp up risk exposures to catch up on funding levels. Long-term swap rates falling below government yields was the main indicator of the first phenomenon – the cashless start to swap contracts making them more attractive investments than spending cash on physical bonds and driving yields down as a result.
And with the Organisation of Economic Co-operation and Development putting the median funding deficit of pension funds in its member states at 26% at the end of 2009 (see figure 2), it is clear that schemes need to improve their funding ratios. So the ability to take on leveraged exposures with minimal cash outlay – a TRS can be written to any nominal position in theory, with the spread above Libor paid by the recipient being the only altered variable – synthetic exposure is receiving more interest from pension funds.
“It is especially prevalent in the UK where many pension funds are underfunded and use TRSs to get more efficient exposure than they could with cash outlays into physical assets,” says Mark Petit, senior structurer at the Rotterdam offices of risk management firm Cardano.
This is echoed by Anil Bangar, head of UK insurance and pensions at the Canary Wharf offices of Barclays Capital. “The central point is to do with leverage. On the basis that the pension scheme may not want to commit the cash necessary for the physical purchase, a TRS allows them to take unfunded exposure. The difference is purely one of whose balance sheet the asset sits on.”
The shift towards using derivatives to improve risk management at pension funds became mainstream in the UK around five years ago, with funds becoming comfortable with first interest rate, then inflation, swaps, and now more exotic derivatives are becoming commonplace.
“The flipside of the growth in demand for TRS is a general improvement in governance at pension funds,” says Andy Harrison, managing director for multi-asset client solutions at London-based asset manager Blackrock.
“There are opportunities out there that they will miss unless they have a broad toolkit available to them, and concentrating on physical assets is not going to allow them to do what they need to.”
But the move towards TRS has been slower on the continent, and some there remain sceptical of what they fear may be simply the latest in a long line of banking-driven product fads, that could be damaging in the long term, especially if it results in relying on unsustainable leverage levels to improve funding.
According to Michael Schütze, head of pensions investment advisory at Allianz Global Investors, the asset management arm of the eponymous Munich-based insurer, the place for leverage is in the so-called alpha – extra returns – part of a fund’s portfolio, rather than its more prosaic beta – liability driven investment (LDI) – part. “A pension fund should only leverage with regards to alpha,” he says. “To improve funding levels it is a matter of strategically finding the right balance between an LDI portfolio and a growth portfolio. The overall position of the pension fund could be leveraged in the end, but that should not come from risks that are uncorrelated to your liability side.”
While TRS started life in the commodities sector as a way for funds to take exposure in oil without having to source the costly and inconvenient storage of hundreds of barrels of crude, the growth in recent years has been in fixed income, and more recently, equities. The reference assets used have also shifted from entirely index-dominated to consisting of bespoke portfolios or specific issuances.
“A big growth area recently is the use of TRS on individual gilts and linkers as a hedging tool,” says David Dean, managing director of the pensions and insurance team at Credit Suisse in London.
“Clients prefer to hedge their duration using gilts and linkers, but do not want the opportunity cost of holding linkers and using up cash,” so TRS became an attractive solution.
But the cashless start can only account for so much – it would all be a moot point if the extra value wasn’t there. This is the view of Bangar, who sees using TRS as a normal extension of cost-efficient asset management, with the added benefit of eliminating basis risk by providing exact benchmark returns.
“The approach taken will be driven by where the fund sees the relative value and what swaps they currently have on. When replacing their existing hedge portfolio they could seek to do this in the nominal space because they see the relative value between interest rate swaps and conventional gilts, or on the inflation-linked side because they are focused on real rates. We see both types of transactions,” he says.
The move into equity TRS is mainly a case of funds liquidating their index-tracking portfolios, using the cash released to buy physical gilts and entering into an equity TRS to retain the exposure. “This is just another way of taking an overall look at the assets and deciding where you want to take leverage. The equity TRS plus physical gilt approach can be a more efficient way of getting the exposures you need,” says Bangar.
According to Blackrock’s Harrison, the value lies simply in the relatively cheap sub-Libor cost of equity TRS. “By selling physical index equity portfolios and replacing with a TRS on an equity index you raise capital for fixed income securities to extend your liability hedge. This has traded at fairly extreme levels.
“For instance, a fund might enter into a TRS on the MSCI World index paying Libor –30 basis points and purchase linkers returning Libor +40bp. There is a funding pick-up, but you still have the equity exposure and an extended hedge. The funding costs do vary though, and tend to be closer to Libor on gilt and linker TRS.”
It is a trend that has been observed at Credit Suisse too, according to Dean’s colleague Tom Frost, managing director of the pensions and insurance team, also based in London. “We have seen pension funds selling their holdings in physical equities, buying gilts, swapping them back to Libor plus a spread, and taking out a total return swap paying Libor minus a spread to receive, for example, the return on the FTSE 100. You get back the position of having exposure to equities, but with a spread on top.”
This is somewhat helped by a more efficient collateral management perspective against alternative ways of getting equity exposure synthetically, such as futures. As futures are exchange traded, they generally require more stringent collateral requirements, plus there is no possibility of netting this across other positions, as the exchanges only cover futures. The over-the-counter nature of TRS mean they have an advantage here.
“If you have an existing interest rate hedge through derivatives, then by taking out equity TRS with the same counterparty you can net collateral across the positions. Since equity and bonds tend to move in opposite directions, you should get efficiencies of collateral management compared with using equity futures where you cannot net off the margin,” says Blackrock’s Harrison.
But collateral tends to be cash or government bonds – and only the latter is helpful for a pension fund – so there is the potential for odd situations when it comes to TRS on the latter. “Cash will basically only yield Libor or Euribor, typically far below your actuarial rate, which also has a very long duration at 15 or 20 years, so it is not suitable for pension funds. So you could have the odd situation of demanding a sovereign bond as collateral for a TRS on itself,” says Allianz’s Schütze.
Other than simply benefiting from the cashless start, collateral requirements and precise benchmark return, a TRS provides a way for funds to take advantage of banks’ operational superiorities. The brokerage markets, in particular the repo markets for short-term lending of securities traditionally essential to short-selling activities, are the natural habitats of bankers and, given their exposure as the writers of the swap, they will have to go into them to buy a hedging portfolio – typically the reference asset itself. This is then available for the fund at the termination of the contract.
“We have seen more trades done on a stopgap basis recently,” says Harrison. “If you don’t have the physical capital but know you will in six months, you can use a TRS to generate exposure. The counterparty has to build a hedge, for example in the repo market if it’s a gilt or linker TRS.
“At maturity, they can try to liquidate it and incur a whole load of transaction costs, or you can just take it off their hands. That way they can unwind their hedge cheaply, you can get the hedging portfolio cheaply and maintain market exposure.”
Perhaps the most outlandish suggestion for a use of the derivatives is another operational advantage – in a world where there is no need for sourcing physical securities, there is no need for staff to source them. This is a distinct twist from fiduciary management, where the front-office functions of risk and investment management are outsourced, as it focuses on the nuts and bolts of obtaining physical securities and administering their cashflows.
“Another appealing thing about TRS is using it to outsource the back office,” says Cardano’s Petit. “There’s some hassle involved in managing physical equity portfolios, so there is an advantage in reducing costs by transferring it to banks, which are more naturally able to deal with this anyway.”
Matthias Schaefer, head of institutional equity and fund derivatives sales at the Zurich headquarters of Credit Suisse, claims Swiss funds have already started implementing this somewhat unorthodox approach. “One client with multiple billions of Swiss francs under management has moved around Sfr1 billion (£636 million) into 20 indexes replicated through TRS on rolling one-year contracts,” he says, although he is unable to name them.
“Each month they simply rebalance among them, which makes it a very flexible asset allocation method. Effectively, they have outsourced a whole chunk of the back office – and this model is an area of growth in Switzerland.”
But Andres Haueter, head of asset management at Pensionskasse Post, the Swiss postal service’s fund, is sceptical: “I don’t think this kind of instrument is well understood in the Swiss pensions sector. We don’t hold any TRSs and it is not a trend I am seeing.”
With Lehman Brothers’ collapse still fresh in people’s minds, the principal risk to a TRS is counterparty risk, coupled with the probable illiquidity during a stress scenario that comes with being part of the OTC market.
Allianz’s Schütze sees this as likely to wipe out any relative value advantages. “After 2008, the management of counterparty risk has become really important. And, for instance, if you take out a TRS on a gilt, you are getting the bond’s return but have exchanged the government’s counterparty risk for a bank’s. So, if you deduct the counterparty risk from the economic arbitrage opportunity, what’s the added value?”
As an example, he compares the different ways of getting exposure to 100 particular bonds – buying the physical bonds directly, buying into an investment fund that holds them, or entering into a TRS. “The question is: can you sell on that TRS when the market is dislocated? When Lehman Brothers collapsed, you could still sell government bonds, and most shares in funds. But could you close out of an OTC trade such as a TRS when the bank is struggling with its own problems?”
He is also sceptical of the collateral advantages in particular, believing it to be poor compensation for the liquidity lost compared to that of an exchange-traded future. “OTC instruments have a clear advantage: freedom of structuring according to the investor’s needs. But you have to have collateralisation and liquidity in mind. Can you sell a TRS in a time of stress? Our managers would always prefer centrally cleared futures because of liquidity and counterparty risk advantages.”
This issue has already affected UK pension schemes looking to buy out. Market sources tell Life & Pension Risk that a handful of pension buyouts have foundered on the unwillingness of insurers to take on TRS as part of the asset pool when they take on schemes.
Frost at Credit Suisse rejects the idea of liquidity concerns as paramount. “I don’t think people are getting into TRS because of the liquidity characteristics. The attraction comes from their unfunded nature and, in some cases, their relative value against alternative instruments.”
The movement of interest rate derivatives onto central clearing could mean the notional collateral advantages disappear anyway, but Credit Suisse’s Schaefer sees this as a plus. “Some people fear this because prices will increase, but I think with the counterparty and liquidity concerns as they are, any increased cost for trading will be more than made up for by reduced costs on the collateral side.”
Whatever the kinks to be ironed out, a TRS remains an interesting – albeit divisive – proposition. Financial innovation is more or less unstoppable, and seeks out those nooks and crannies in the market where currently available alternatives are not meeting the particular demand circumstances. The outlook for the product is unclear precisely because the evolution of pension risk management is.
“The future outlook for TRS depends on what investors look for from their asset managers. If investors are attracted to the clarity of an exact return of an index, and are comfortable with the mechanics, then we could see volumes continue to increase,” says Credit Suisse’s Frost.
What is a total return swap?
In general, a total return swap (see figure 1) is an exchange of the mark-to-market changes and dividend or coupon payments of any security or index of securities, in return for a funding rate, usually Libor plus or minus a spread. The two counterparties are known as the payer (TRP) and receiver (TRR), with the former typically owning the reference asset and having a lower cost of funding (such as a bank), while the latter has a weaker balance sheet or uses leverage.
The cashflows are:
Total return payer (TRP):
- Pays total positive return of asset(s) – mark-to-market increases plus any coupons or dividends
- Receives Libor +/- spread
- Typically owns reference asset(s) as hedge
Total return receiver (TRR):
- Receives total return of asset(s)
- Pays Libor +/- spread
- Pays mark-to-market losses