Index swaps are used by investors to:
1) replicate or and enhance the total return of a specific sector of the fixed income market; and
2) hedge market risk. The following sample trades illustrate the some common uses:
■ Examples
• Achieving diversified exposure. An insurance company desires diversified exposure to the high yield bond market. Cash market purchases, however, are
inefficient, expensive and difficult to accomplish in size for many individual issues. The insurance company enters into a six-month swap with Merrill Lynch where Merrill Lynch pays quarterly the total return on the High Yield Master index and the insurance company pays a LIBOR-based spread. The insurance company pays a LIBOR-based "funding spread" (which varies according to market demand for each index swap) but does not pay any bid/offer costs on the 829 underlying high yield bonds and does not put any assets on their GAAP balance sheet.
• Hedging systemic market risk. A fund has the mandate to generate returns above LIBOR by investing in a variety of investment grade fixed income assets and can buy asset swaps or overlay swaps to achieve its objective. The fund manager buys investment grade corporate bonds using the in-house expertise in the fund manager's credit department and then enters into an index swap with Merrill Lynch where the fund manager pays the total return on the Corporate Master index and receives a LIBOR-based spread. The manager has historically outperformed the index and if he continues to do so would generate a return above LIBOR with reduced systemic corporate market risk.
• Managing execution risk. Similar to the use of S&P futures by equity money managers, fixed income investors may pay or receive on index swaps to immediately subtract or add risk to the broader corporate market. The index swap is then unwound as suitable bids and offerings are sourced on desired underlying issues.
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An index swap is a total return swap on an index of bonds. Merrill Lynch produces and maintains over 2,000 proprietary indices designed to help investors measure performance of various markets and their own portfolios against an appropriate benchmark. In a total return index swap, one party agrees to exchange the total return (coupons plus price change) of a specified index for another rate of return, usually LIBOR or another bond index
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Applications
Total return swaps have four uses: hedging, leverage, market access, and balance sheet management
Total return swaps have four general uses. They are used to:
1. Enter into hedge or "short" positions. Investors can pay "total return" on an asset or basket of assets to obtain an off-balance sheet, term short position.;
2. Obtain leverage. The list of eligible assets for total return swaps is more extensive than bank-financeable assets and includes some illiquid assets such as offshore hedge funds and private placements;
3. Access markets efficiently. Total return swaps on corporate bank loans allow non-banks to enter the loan market without establishing elaborate and costly funding and processing operations; and
4. Improve return on capital and manage balance sheet usage. Total return swaps are off balance sheet instruments for GAAP purposes. As such, any positive return on a total return swap enhances return on GAAP equity since only the mark-to-market value, if positive, is an on balance sheet asset.
Examples
Leveraged investment in a fund. Investors can enter into a total return swap on an investment or sector fund. The investor receives all the cash flows from the fund and enhances returns through the use of leverage.
Synthetic repo. A money manager that anticipates spread tightening lacks current liquidity with which to fund investments. By receiving total return on one or more corporate bonds, the money manager can lock in the purchase price of assets while minimizing capital commitments, thereby disaggregating market timing from liquidity constraints.
Synthetic CBO. Investors can in effect create their own customized
collateralized bond obligation by entering into a total return swap on a basket of high yield bonds. The investor would choose the bonds and may be required to post initial margin in the form of cash collateral or securities. Merrill Lynch can provide an out of the money "put" on the basket that limits the investor's loss to the initial margin amount. The net effect is similar to the leverage and limited risk inherent in an equity tranche in a CBO. The advantages of this transaction are its ease of setup, the ability of the counterparty to alter the bonds in the swap (subject to certain limitations), and the ability of the investor to customize the structure (size, put strike, fixed or floating funding).
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