5: Collateral Swaps & TRS

Mini Chapter five

Collateral Swaps

Collateral Swaps is the exchange of two different assets for any given tenor. The lender of the lower quality collateral generally pays a spread to the lender of the higher quality collateral. The assets can be and generally are in two different currencies. The motivation for these trades is largely portfolio optimisation wherein a passive investor could enhance the portfolio returns by swapping collateral (credit risk) without necessarily taking market risk on the weaker underlying. Treasuries in banks use these to acquire say higher yielding but High Quality Liquid Assets (HQLA) assets again without taking the associated market risks. 

Typically above investment grade internationally rated (offshore) and equivalent locally rated sovereigns qualify for HQLA for the Global Banking system. In the same vein, (from the previous section) – Japan sovereigns (high rated and HQLA eligible) are/can be higher yielding versus local sovereigns, the only difference is that the holder would be exposed to mark to market risk.

• Connecting the Dots

One can also think of collateral swaps as undertaking a repo purchase of an asset against a repo sale of the other asset.

Pricing of a collateral swap

The spread to be charged for a collateral swap should be the differential of the respective repo spread/asset swap spread of the exchanged assets. Or said another way the lower grade asset gets financed by the higher grade one, hence the difference between the asset swap return on the lower grade asset and repo funding cost of the higher grade one guides the collateral swap pricing.

As an example – a foreign dealer who buys a Korean bond at an asset swap spread of USD SOFR + 100bps would be willing to pay a spread of ~70bps to do a collateral swap of the Korean bond against an IG bond. This IG bond could be repo-ed/ traded at an asset swap spread of USD SOFR+30bps. The dealer can use the IG asset to generate funding at SOFR +30bps and can fund the Korean asset at an overall cost of USD SOFR +100bps (including ~70 bps collateral swap spread).

Bond Forwards

Bond Forward are a product used by investors who anticipate the need to deploy cash in the future but want to lock in the current level of rates for that future purchase. This can be because a) they do not have the cash for immediate deployment b) they are in need of duration for their portfolio to correct duration mismatches between assets and liabilities c) for leveraged/enhanced return d) relative attractiveness of bonds vs swaps i.e. wider bond-swap spreads. You can simply think of it as a bond trade being priced for a future date, where the pricing is based on the spot price of the bond and the anticipated funding rate for the forward tenor. In the repo section we explained how the futures/forward price and spot price determine the implied repo/ funding rate of the bond. As a corollary, if we know the spot price and the funding / repo rate of a bond we can derive the no-arbitrage forward price of the bonds just like the forward prices on swaps.

If the yield curve is upward sloping i.e. repo rate for the tenor of the bond forward (say a 5y tenor of a 5y forward 20 year bond) is lower than the yield on the longer tenor bond (25 year bond) then the forward bond price will be lower (yield will be higher) than the current price of the bond.

Notional limit on being able to offer bond forwards would depend on the balance sheet capacity of banks.

• Trivia

We have seen increased use of bond forwards by lifers in markets like Korea and India to increase duration risk in a portfolio similar to receiving fixed on long dated IRS but at a better yield given the positive bond-swap spread. The dealer (seller of the bond forward) needs to cover his short position on the bond by buying the bond in the cash market and or think of cheap ways of funding the same since emerging markets don’t really have active term repo markets.

• For eg. pricing of a 2y forward 30y IGB would involve buying the 30y IGB and pricing/funding it for 2 years at OIS + spread, effectively running a balance sheet position and a funding mismatch.

• For a highly rated market like Korea with attractive asset swap levels, one can think of tying up cheap KRW funding by doing a combination of collateral swap and a USDKRW cross currency i.e swap for the forward tenor. For instance a 2 year forward bond structure can be executed by first doing a 2 year collateral swap i.e. exchanging KTBs for USTs at a fixed running fee of say 25bps (something that’s incentive enough for the UST lender). The USTs can be refinanced (repo-ed) for term USD cash which can be converted to KRW cash by doing a 2y Cross currency swap to fund the KRW bond purchase.

Total Return Swap (TRS)

Total Return Swap (TRS) is a contract wherein the buyer gets access to the economics/ cash flows of an asset on one leg via a derivative versus paying funding on the other leg of the swap. Key difference between a TRS and an asset swap – in case of the latter one physically holds the asset, returns of which are directly credited to asset holder with the swap used to hedge the interest rate or FX risk, while in a TRS all underlying returns of the asset  are passed on to the holder but they don’t physically hold the asset.

• The underlying asset could be of any type with certain/defined or uncertain cash flows (bond/fund/equity/real estate). Note the underlying asset could also be of any maturity or even a perpetual as the TRS buyer is only buying the return of the asset for a specific time period.

• Connecting the Dots

The funding leg could be seen as the repo price of such an underlying asset else arbitrage conditions could exist.

• Valuation of the asset leg of the TRS – Despite being a derivative that would conventionally reference CSA documentation, the present value calculation of the asset price at the time of unwind automatically references its current market price (in case of bonds it’s the current YTM). This is because the PV obtained from CSA discounting won’t align with traded market levels of the underlying as funding costs differ. This is a well accepted understanding between both the TRS seller and buyer who can unwind the TRS at any time before the swap tenor sometimes with an additional break funding charge. 

For those not familiar with break funding – this is an additional charge levied by the seller of the TRS (writer) who is expected to pay up their treasury in full the cost of the TRS funding tenor. A premature unwind would require the TRS buyer to pay up (make-whole) the residual funding charges to the seller. These are also known as ‘make-whole’ charges.

• Since only the cash flows of the underlying asset are paid by the TRS writer – the title of the underlying asset remains with the TRS writer who also continues to own things like voting rights etc.

• TRSs are mainly used to address access issues i.e. TRS buyers have hurdles in directly accessing the markets of the underlying, for eg. ODIs (offshore derivative instruments are TRS exposures for offshore investors on onshore INR assets) in India.

• Trivia

TRS contracts are bilaterally negotiated and lack standardisation (unlike CDS contracts), hence dealers can differ in their valuations of such contracts even if economic terms are similar. As a result, novation of the contract to another dealer/bank gets difficult. For instance TRS valuation of a fixed rate sovereign bond to maturity could also be valued as risk free cash flows in that currency (i.e. like a fixed leg of an onshore IRS) since we know that the cashflow up to the bond maturity is fixed.