Total Return Swaps and Sovereign Debt Sustainability: Evolving Use of Innovative Debt Products

Sovereign borrowers and issuers operate in a dynamic financing landscape in which commercial counterparties have long sought, with varying degrees of success, to establish some form of priority or enhanced credit protection. Over the course of years, many innovative debt products – from commodity-linked prepayment facilities, resource-backed lending, repos and bilateral secured arrangements – have all been deployed as alternatives or supplements to conventional bonds and loans, driven by need, speed and executability. Total return swaps are only one instrument among many in this environment, but their recent use by sovereigns has attracted significant attention. The IMF stated recently that transacting in TRS "carr[ies] risks" and that these transactions can be "opaque so the terms are not always very transparent". The World Bank's former president, David Malpass, stated more bluntly that TRS is "creating a new race toward seniority in the [sovereign] capital structure".

Those concerns raise legitimate questions – but they are not new, and nor in many cases are they unique to TRS. Questions of opacity, creditor priority and stress-time vulnerability have arisen across a range of collateralized and structured sovereign financings over the years. That broader context should not obscure the practical reasons why sovereigns may consider TRS alongside other structured instruments.

For borrowers and issuers facing high debt costs, limited market access or tight foreign currency liquidity, a TRS may offer liquidity, execution certainty or tailored risk allocation where a public bond, loan or other source of financing may be difficult, slow, expensive or politically unattractive. It can also give a sovereign a means of managing exposure to particular assets or financing needs in a more tailored, flexible manner, without using the more widely-held channels of benchmark issuance or syndicated lending. The question for governments, creditors and official sector institutions is therefore not whether any particular financing instrument is inherently desirable or undesirable, but how the economics, collateral and stress-case consequences are understood and managed.

The purpose of this client briefing is two-fold:

• first, we discuss how TRS are typically used as a source of funding, how they compare to other forms of financing (such as bonds, loans, repos and official sector financing), and what challenges market participants (lenders and borrowers alike) face when compared either to those other forms of financing;
• secondly, we look at TRS in the context of the ongoing sovereign debate around how to achieve better debt transparency, facilitate more effective debt restructuring and resolve the preferred creditor status (or treatment) of multilaterals and development finance institutions.

What is a TRS?

A TRS is a derivative under which one party pays amounts linked to the total economic performance of a reference asset, while the other party typically pays a financing rate or other agreed return. In a bond-referenced TRS, the “total return” side generally captures the coupon or income on the reference bond plus gains or losses from movements in the bond’s market value. The economic effect is that one party can obtain exposure to the reference asset without necessarily buying it outright, while the other party can retain or intermediate the asset and receive financing-style payments.

See diagram 1 for an outline of these basic cashflows.

How can a TRS be used as a form of financing?

A total return swap of itself is not a financing instrument. However, it can be combined with other instruments to achieve a similar economic effect. In particular, if the total return receiver sells the reference bond at inception of the TRS, and purchases it at maturity of the TRS, the combination of the sale, TRS and repurchase is that the total return receiver receives cash (the sale proceeds of the reference bond), pays financing costs under the TRS, and repays the cash (the purchase price of the reference bond). During the life of the transaction, the reference bond might be seen as economically performing the role of collateral, together with mark-to-market collateral provided in respect of the TRS.

See diagram 2 for an outline of how the cashflows of a TRS together with a sale and repurchase can provide the total return receiver with funding.

How do TRS compare with other types of debt?

We set out below key differences, in terms of form, documentation and economics, of total return swaps and other typical debt¹ financing arrangements. There will typically also be accounting and regulatory differences, as well as differences in regulatory capital treatment, but from a sovereign financing perspective these are more likely to be questions for the finance provider rather than the sovereign borrower.

As can be seen from the above table, a number of the differences between the various instruments are connected. A TRS counterparty (like a repo counterparty) typically has the ability to call for daily margining (or "top-up collateral") if the value of the collateral portfolio deteriorates. In this way, it can keep the loan-to-value ratio at a relatively stable level (or at least within defined parameters), and maintain a consistent (or acceptable) level of over-collateralization.

Because the collateral is typically highly correlated to the sovereign's credit risk, this over-collateralization and daily margining may still expose the TRS counterparty (or repo counterparty) to potential credit risks. This is, in turn, managed by additional credit triggers which allow the counterparty to take remedial action if certain events occur which might indicate a deterioration in credit risk, market risk or liquidity of the collateral.

These triggers may include adverse foreign exchange movements, a default on the collateral or other debt issued by the sovereign and the securities or cash becoming subject to transfer restrictions in the domestic market or from domestic accounts to foreign accounts. They may also include broader market disruption events such as volatility, liquidity and market limitations.

Depending on the risk profile of the transaction, the consequences of these (and other) triggers may be a mandatory prepayment obligation, cash settlement of the transaction, or step-ups in the level of over-collateralization.

The bespoke nature of TRS and repos means that the parties are able to isolate individual risks (such as credit risk, foreign exchange risk, market risk and liquidity risk) and provide for specific outcomes should those risks materialize. Because TRS and repos include margining and bespoke additional triggers, the counterparty is less reliant on the more extensive covenants and events of default that are typically found in loans and official sector financing. It also means that the counterparty is able to keep the cost of funding down, as it can discount the price of each of these risks.

In comparison, a lender under a loan or official sector financing is more reliant upon extensive covenants, and has to price into the cost of funding the full extent of credit risk, foreign exchange risk, market risk and liquidity risk. This means that the cost of funding may be higher than that which would be available using TRS or repo. An investor in a public bond is similarly exposed to such risks, which would impact the bond pricing and liquidity.

Why sovereigns may look at TRS

As noted above, pricing is likely to be a factor. Collateralized financing can sometimes be cheaper than unsecured market borrowing because collateral reduces the counterparty’s expected loss and monitoring costs. From a sovereign’s perspective, that pricing benefit can be particularly relevant where market access is constrained, external debt service is concentrated, or conventional borrowing would come at a high coupon. The key policy and legal question is whether the apparent saving remains a true saving after taking account of collateral opportunity cost, margin call risk, disclosure effects, debt sustainability implications and potential interactions with other creditors.

As well as these potential pricing benefits, sovereign borrowers may consider TRS for more practical reasons. IMF work on sovereign repo arrangements notes that such arrangements may allow sovereigns to raise funds more quickly than through a formal issuance process and may help avoid saturating an institutional investor base when issuance needs are large. Similar considerations would be relevant to a TRS where a sovereign is seeking speed, certainty of execution or a structure that can be arranged bilaterally with a financial counterparty.

Why the current focus? IMF observations and wider policy questions

The IMF's most detailed recent public intervention arose in connection with Nigeria's proposed US$5 billion TRS with an international bank, collateralized at 133 per cent. with domestic government securities and carrying an interest rate comparable to Nigeria’s Eurobond yield. The IMF identified complexity, FX-related margin-call exposure and potential monetary or exchange-rate policy constraints as key issues.

Those issues can be grouped into two broader categories: transparency and stress-time liquidity.

Opacity and transparency. The concern is less that a TRS is inherently opaque than that bilateral, collateralized financings can be difficult for other creditors and official sector institutions to identify and assess. The IMF and World Bank have noted that data on collateralized sovereign transactions are not collected systematically by borrowing-country debt management offices and are only sparsely available to IFIs. In particular, TRS may pose a challenge for multilateral financial institutions with preferred creditor status, who are inherently skeptical of debt instruments which create (or are perceived to create) priority for commercial creditors, and apply scrutiny towards those.

In a market moving towards enhanced sovereign debt transparency – reflected in initiatives such as the London Coalition on Sustainable Sovereign Debt and its bondholder working group’s proposals for model transparency clauses covering investor relations, periodic debt disclosure and high-level reporting of confidential debt information – creditors would expect that a TRS that creates financing-like exposure should be capable of being described in debt statistics, fiscal risk analysis and creditor communications at a level sufficient to understand size, tenor, collateral, margin mechanics and termination exposure. A TRS does not have to be opaque or complex by definition, and it is possible to document them in a manner which is clear and intelligible. Where TRS documentation includes non-disclosure provisions, however, the sovereign may face tension with its reporting obligations to official-sector creditors.

Margin-call vulnerability and policy sensitivity. Mark-to-market margin maintenance can require a sovereign to post additional collateral when collateral values fall or FX movements go against it. Where the collateral pool is highly correlated with the sovereign’s own credit risk, the call can arise at a time of financial strain. In our experience, sovereigns are fully aware of and sensitive to the risks of margin calls and will require appropriate protections, for example the ability to dispute valuations.

Those risks can sometimes be allocated differently. For example, FX risk may be excluded from margining, but the counterparty will instead need to manage that exposure elsewhere and may pass the hedging or capital cost back to the sovereign through pricing. There is a trade-off between risk allocation and pricing.

Stress, default and restructuring scenarios

In a default scenario, the mechanics of a TRS will depend on the documentation, governing law, collateral package and close-out provisions. TRS are commonly documented under an ISDA framework, which would typically allow the counterparty to close out the transaction, determine the close-out value and apply top-up collateral under the agreed credit support arrangements. As a synthetic product, the close-out value reflects changes in the value of the reference asset.

For a sovereign, the key point is that the TRS counterparty’s exposure may be measured by reference to depreciation in the reference asset, after taking account of collateral already received, rather than by reference to the gross financing amount. Close-out, collateral, netting, set-off and enforcement rights can therefore place the counterparty in a stronger practical position, potentially altering de facto seniority in stress. As a result of, for example, capital incentives, TRS counterparties will typically require a clear and rapid path to collateral realization – where correlated collateral is liquidated, a distressed sovereign may face par claims from both purchasers of that collateral and the TRS financing counterparty.

In a restructuring or Common Framework context, the question is how that position interacts with comparability of treatment, creditor coordination and the perimeter of claims to be treated. It is not clear that the current sovereign debt architecture – including the Common Framework and the Global Sovereign Debt Roundtable – yet has generally accepted tools to measure and compare the embedded seniority, close-out economics and collateral positions of TRS-style instruments against conventional bond or loan claims.

Transparency, negative pledge and official sector architecture

A borrower under any type of financing arrangement inevitably needs to consider not only counterparty economics, but also disclosure to other stakeholders and creditor classes within their legitimate expectations. The broader direction of travel, reflected in initiatives such as the London Coalition, is towards clearer contractual transparency and better reporting of public liabilities. Where a TRS creates financing-like exposure or contingent collateral obligations, the question for borrowers and lenders alike is therefore how TRS fits within this context.

Collateral arrangements also require careful restrictive covenant review. For example, depending on the collateral, grantor, asset location, maturity, covered debt definitions and exceptions, TRS collateral may interact with the World Bank negative pledge. In this regard, it may be important to consider not just the strict legal analysis as to how a TRS interacts with the World Bank negative pledge, but also how the World Bank applies those provisions in practice.

Under Section 6.02 of the IBRD General Conditions, if any “Lien” is created on “Public Assets” "as security for" “Covered Debt” that may result in priority for the creditor in the allocation, realization or distribution of foreign exchange, that lien must equally and ratably secure all amounts payable to the World Bank (or alternative security must be offered). “Lien” is defined broadly to include “mortgages, pledges, charges, privileges and priorities of any kind”.

Market participants who are familiar with TRS, repo and other title transfer arrangements will generally scrutinize proposed transactions carefully to ensure that transactions do not contravene applicable negative pledge provisions. Often this will be on the basis that the arrangement will not give rise to "security", and that the financial exposure does not constitute indebtedness. However, some forms of debt finance arrangement will contain other restrictions, such as restricting the use of title transfer arrangements which have a similar economic effect to borrowing.

As noted above, in the context of the World Bank negative pledge, how the World Bank itself chooses to interpret and apply these provisions as a policy matter may be equally as important as the strict legal analysis. The World Bank has historically treated arrangements creating a creditor preference over public assets – including deposit and set-off structures – as falling within the clause. “Public Assets” encompasses assets of the member country, its subdivisions and entities owned, controlled by, or operating for its account or benefit, including central bank reserves.

As of the writing of this note, the question of how the World Bank treats TRS arrangements which involve – economically – collateral or title-transfer mechanics over sovereign or central-bank securities is essentially untested. Sovereigns and their counterparties should consider this issue during product design, not during a stress episode.

A related policy consideration is the interaction with the preferred creditor status (or treatment) of multilateral development banks. Certain multilateral financial institutions, including the World Bank and IMF, are conventionally excluded from burden-sharing in sovereign debt restructurings on the basis of numerous factors (including their focus on concessional lending, truly global membership, and a development-focused mandate). If a TRS counterparty’s collateral position gives it de facto seniority comparable to, or in competition with, the claims of preferred creditors, then – if the transaction is sufficiently material - it may reduce the pool of assets and foreign exchange available to service multilateral obligations – precisely the outcome the World Bank negative pledge clause is designed to prevent.

A space for sovereign TRS alongside other financing solutions

Any sovereign debt facility starts with a clear public debt-management purpose. Before execution, the sovereign and its advisers should set out to explain what problem the financing is solving, how it compares to available alternatives, and how the full lifecycle cost changes under stress. These processes apply equally to TRS as they do to other instruments, with the added requirement to conduct margin-call stress testing, determine collateral opportunity cost, funding sources for top-ups, early termination exposure, debt reporting treatment, restrictive covenant compliance, likely treatment in a restructuring and the implications for the sovereign’s relationship with its multilateral creditors.

Product design can also help. Calibrated thresholds and minimum transfer amounts, transparent valuation mechanics and clear trigger consequences, as well as (where appropriate) governance approval by the debt management office and/or finance ministry will make it easier for the sovereign to balance its use of TRS with disclosure commitments to the IMF, MDBs or other creditors.

None of these features removes risk, but each can make the risk easier to understand, price and manage.

Conclusion

Used with suitable disclosure, careful review of the commercial and economic terms, and full integration into fiscal risk analysis, TRS can be one financing tool among many for sovereign borrowers and issuers facing difficult market windows and concentrated external financing needs. In fundamental terms, a TRS is not unlike other bilateral or secured financing arrangements, but it can offer speed, flexibility and, in some cases, a lower cost of execution. Used without discipline, however, TRS – like other structured financing instruments – can create contingent liabilities, liquidity strain and creditor-coordination issues that are harder to manage in stress. Where TRS sits in the complex creditor hierarchy that would arise on a sovereign debt restructuring is also not something that the more traditional debt architecture currently has obvious tools to resolve.

The path forward is not to discourage innovation, but for borrowers and issuers to be disciplined in how they embrace it – and, to the extent there are concerns about particular instruments, for creditors to consider what information and protections they require going forward. TRS, repos, bonds and loans are different legal instruments – but, in sovereign finance, form is only the starting point. These are not new questions. The harder question is how each instrument affects liquidity, debt sustainability, transparency, creditor hierarchy, and creditor comfort as to the sovereign's capacity to repay. That is where the challenge begins.

Authors: Daniel Franks, Partner; James Coiley, Partner; Tom Longmuir, Partner and Sanju Ganesan, Associate.