November 21, 2024 - On November 20th the LSTA hosted a webinar, “Loan Total Return Swaps: What You Need to Know” which was presented by the Crowell & Moring LLP team led by Jennfier Grady, Partner, and Richard Lee, Partner, and John Clark, Special Counsel.
There has been an uptick in activity in the Loan Total Return Swaps (LTRS) market in the past couple of years after a marked downturn in volumes following the implementation of the Dodd Frank margin rules. With the uptick in volumes, new regulations have more recently also been implemented, for example, an anti-fraud regime has been put in place in LTRS which is impacted by MNPI issues. Thus, the presenters highlighted that now is a good time for a refresher on the product and for market participants to be aware of the issues which may arise.
Market participants in LTRS include dealers and banks, as swap dealers, on one side of the transaction, and on the other side of the transaction, hedge funds, insurance companies, CLOs, pension funds, and other alterative vehicles all becoming swap counterparties.
The vast majority of LTRS transactions reference par loans and although not a significant portion of the market, there is a growing volume of par loans that are being placed on swap. Although it is hard to estimate the size, it is evident that the LTRS market has been growing in the past couple of years.
All types of bank loans are now traded through TRS arrangements, for example, revolving loans, distressed loans (though these are rare because dealers will want to exit the position if there is a credit event to protect themselves), European loans, and even bankruptcy claims. The LTRS product is flexible enough to cover many different types of assets.
LTRS typically enable market participants to go synthetically long an underlying asset. It is a pure derivative instrument, and thus, no ownership is transferred; only the economics of the underlying asset are transferred. Currently, the primary use case of this LTRS product is to obtain leverage on the synthetic purchase of bank loans. The second use case is for a swap user to outsource the administration of a loan position and the associated operational burden of maintaining a bank loan position.
Market access is the third use case. The credit agreement may include eligibility restrictions which prevent certain parties from acquiring the bank loan, but that credit agreement may permit them to access the loan via a swap. Thus, parties may gain access and exposure to assets that might not otherwise be readily available to them.
The basic structure of a TRS contract is a bilateral derivatives contract reflecting a stream of floating rate payments in exchange for the return on one or more underlying assets. The “Total Return Receiver” (typically a hedge fund or CLO) wants the economics of an underlying bank loan and pays a funding cost – a financing charge to the “Total Return Payer” (typically bank or dealer) in exchange for all of the economics – the total return on an asset. TRS is very similar to a financing arrangement.
Notably, the total return payer may, but is not obligated to, purchase the loan to “hedge”. So long as the TRP has visibility into the payments of the borrower, they can mirror them. If the total return payer chooses to hedge, it will often set up a special purpose vehicle. The dealer sits in the middle of the transaction and passes cash flows back and forth.
There are two types of collateral in these transactions – the first type is referred to as the independent amount or the “haircut”. This upfront collateral will need to be posted on the trade date. The upfront collateral protects the LTRS dealer from the risk of default of the counterparty as well as from general market volatility. Thus, if the swap counterparty defaults on the swap, the dealer will have contractual rights to enforce against the counterparty, but the dealer will have to wait and then fulfill certain obligations before it can exercise those contractual rights.
The second type of collateral is the daily collateral. This collateral is posted daily to support changes in mark to market valuation and is referred to as “variation margin” and is required to be posted by swap regulations. This second type of collateral protects the dealer from depreciation in the market value of the loan. The total return payer calculates the value of the loan on a daily basis and if it decreases in value then the total return receiver will post more collateral and if it increases it will return some of the variation margin that was posted on a daily basis to the total return receiver. Upon termination of the swap, if the loan has depreciated in value the total return receiver will be responsible for paying that depreciation amount to the dealer.
The presenters then explained the TRS documentation which includes the ISDA Master Agreement, the ISDA Credit Support Annex, and the TRS Swap Confirmation.
LTRS has been used for many years in the loan market with volumes fluctuating and now is helping to create healthy demand in the par loan market by providing an additional access tool both to allow traditional loan market participants to diversify their risk across multiple access points and to draw in new participants. This is a hybrid instrument, a derivative wrapped around a loan thereby creating a security-based swap subject to Rule 10b-5. This creates questions for market participants and complexities for dealers. If an LTRS dealer is public from an information perspective but is acting for a swap counterparty that is private and that may have borrower level information then that dealer may have a challenge. The product creates a further need for diligence for market participants who should be careful with the management of information in such contexts.
Click here for the replay and slides.
