Advice on a total return swap product

[brfish]

I need some advice on this.

My RM recommended me this product. Her sales pitch was that because the cost of money for China banks are higher than my local bank, they created a total swap product to make use of that.

Per my layman understanding, how this works is like you borrow money from the local bank, which is used to purchase the bond of several China banks. As the return on the China banks are higher than the rate of the loan, you make money off it. And the bank give it a large leverage so amplify the earnings.

It makes sense to me on paper. Just want to see if there's a catch that I missed. My understanding is that the risk I bear is that if one of the China banks go default then I'll be in huge debt due to the leverage.

Do you think it's a good product?

 

[tangent314]

I seriously hope that she is recommending this product only because you already have a lot of retirement savings in low risk investments, and have spare cash on top of that to play around with some high risk investments.

 

[Knight_Rider]

You can borrow in Yen or CHF as their interest lower. You swap back to SGD when exchange goes too high. Then you leverage to invest in a higher interest product to pay the bank. You must also be above average in FX.

 

[Majestic12]

Why isn’t the bank using its own capital for this?

 

[brfish]

But then I'm exposed to the FX risk. Here it is the default risk of the bond issuer. Different type risk, no?

You can borrow in Yen or CHF as their interest lower. You swap back to SGD when exchange goes too high. Then you leverage to invest in a higher interest product to pay the bank. You must also be above average in FX.

 

[kilaalaa]

Actually why is the bank introducing you this product? Is it because you have a lot of investments in low risk instruments? If so, this total return swap product is not really for you. This is a derivative and is leveraged, so this is honestly riskier than equities if you ask me.

Did they share details about the bonds that you will be swapping? The currency that the bonds are denominated in?

Lets say for example you are swapping A) Chinese Bank 3% CNY bond with B) SG Bank 2% USD bond.

At the end of the contract period, you receive the Chinese bank 3% CNY bond return, but you pay to your counterpart SG Bank 2% USD. However, if Chinese bank 3% goes below 2%, you will lose money. Even if interest rates don't change but CNY depreciates against USD more than the interest rate differential, you will lose money. You could also make money if everything turns out well.

This is a leveraged product, because you will make or lose money depending on the above scenarios, multiplied by the notional amount of the swap contract. If everything goes well, you could make money off a smaller capital base, because you don't have to put up the full notional amount as capital. The leveraged nature of the swap boosts your returns in this case. But if things turn out badly, you could also lose more money than you have.

Personally I wouldn't invest in this.

 

[DukeCS33]

There is an inherent FX risk in this - did the Bank fix the rate upfront to eliminate this risk? There is a hugh spread in built into this and usually to the detriment of the buyer.

 

[lifeislonggamma]

Great timing by the bank/RM, just when the PBoC is telling China banks to buy more lower-grade corporate debt.

 

[Shiny Things]

I need some advice on this.

My RM recommended me this product. Her sales pitch was that because the cost of money for China banks are higher than my local bank, they created a total swap product to make use of that.

Per my layman understanding, how this works is like you borrow money from the local bank, which is used to purchase the bond of several China banks. As the return on the China banks are higher than the rate of the loan, you make money off it. And the bank give it a large leverage so amplify the earnings.

It makes sense to me on paper. Just want to see if there's a catch that I missed. My understanding is that the risk I bear is that if one of the China banks go default then I'll be in huge debt due to the leverage.

Do you think it's a good product?

I mean, you've basically got it. It's a GIGANTIC leveraged bet that Chinese banks won't default on their bonds. My guess would be that if even one of the "several" banks defaults, you're going to get completely wiped out.

From what you describe, I can't see if there's an embedded FX bet or anything like that in there.

My worries would be:
* Total return swaps have a loan hidden inside them, and they're probably ripping you off on the loan rate;
* Do you have any idea what banks' bonds they're going to buy on your behalf? Are you getting a big, boring bank; or a tiny regional bank that might blow you up; or are they, god forbid, sticking you in a few Chinese real-estate bonds as well? Do you know anything about the Chinese bond market, or are you trusting that the bank cares more about its customers than its profits? (hint: THEY DON'T).

Frankly, I think they're trying to take advantage of you. They're probably dangling a huge yield in front of you, hoping that you won't notice two things:
1) The risk of completely blowing yourself up - for more than the amount you put in! - if just one of the underlying bonds defaults;
2) The huge hidden fees they'll be ripping out of you. There are a zillion places to hide fees inside a TRS - marking up the funding rate, fiddling with the terms of the swap, etc etc - and there's no way you'll spot if the bank's trying to pull a fast one on you.

 

[parchiao]

I need some advice on this.

My RM recommended me this product. Her sales pitch was that because the cost of money for China banks are higher than my local bank, they created a total swap product to make use of that.

Per my layman understanding, how this works is like you borrow money from the local bank, which is used to purchase the bond of several China banks. As the return on the China banks are higher than the rate of the loan, you make money off it. And the bank give it a large leverage so amplify the earnings.

It makes sense to me on paper. Just want to see if there's a catch that I missed. My understanding is that the risk I bear is that if one of the China banks go default then I'll be in huge debt due to the leverage.

Do you think it's a good product?

Layman understanding vs Long a Total Return Swap where underlying are Chinese banks issued debt denominated in CNY financed through borrowing and leverage.



You must be incredibly rich or incredibly something else to even consider something you don't need.

And drop the RM too.

 

[brfish]

I mean, you've basically got it. It's a GIGANTIC leveraged bet that Chinese banks won't default on their bonds. My guess would be that if even one of the "several" banks defaults, you're going to get completely wiped out.

From what you describe, I can't see if there's an embedded FX bet or anything like that in there.

My worries would be:
* Total return swaps have a loan hidden inside them, and they're probably ripping you off on the loan rate;
* Do you have any idea what banks' bonds they're going to buy on your behalf? Are you getting a big, boring bank; or a tiny regional bank that might blow you up; or are they, god forbid, sticking you in a few Chinese real-estate bonds as well? Do you know anything about the Chinese bond market, or are you trusting that the bank cares more about its customers than its profits? (hint: THEY DON'T).

Frankly, I think they're trying to take advantage of you. They're probably dangling a huge yield in front of you, hoping that you won't notice two things:
1) The risk of completely blowing yourself up - for more than the amount you put in! - if just one of the underlying bonds defaults;
2) The huge hidden fees they'll be ripping out of you. There are a zillion places to hide fees inside a TRS - marking up the funding rate, fiddling with the terms of the swap, etc etc - and there's no way you'll spot if the bank's trying to pull a fast one on you.

Thanks a lot for the feedback.

To the points you called out
1) I've seen the list of bonds. They are actually the big boring banks. State owned which from my perspective, if they are defaulting their bonds the whole China economy is blown up. That's not impossible but probably some risk I can take if the total amount isn't going to wipe me out

2) That part I have no visibility and I guess I'll not be able to find out. One question I have is that, given that this is a simple product (borrow with lower interest and put in bond with higher return), is there anyway as an individual to exploit that interest difference hence avoid the hidden fees from bank?

 

[Majestic12]

Dude, Lehman was boring too.

Thanks a lot for the feedback.

To the points you called out
1) I've seen the list of bonds. They are actually the big boring banks. State owned which from my perspective, if they are defaulting their bonds the whole China economy is blown up. That's not impossible but probably some risk I can take if the total amount isn't going to wipe me out

2) That part I have no visibility and I guess I'll not be able to find out. One question I have is that, given that this is a simple product (borrow with lower interest and put in bond with higher return), is there anyway as an individual to exploit that interest difference hence avoid the hidden fees from bank?

 

[Shiny Things]

Thanks a lot for the feedback.

To the points you called out
1) I've seen the list of bonds. They are actually the big boring banks. State owned which from my perspective, if they are defaulting their bonds the whole China economy is blown up. That's not impossible but probably some risk I can take if the total amount isn't going to wipe me out

Be aware that you're on the hook for the total leveraged amount.

2) That part I have no visibility and I guess I'll not be able to find out. One question I have is that, given that this is a simple product (borrow with lower interest and put in bond with higher return), is there anyway as an individual to exploit that interest difference hence avoid the hidden fees from bank?

Mmm... sort of? You could construct the trade yourself by buying the bonds directly and leveraging up, though you'd have to do that through a bank anyway, since I'm guessing these are not listed bonds. (The other advantage of doing it yourself is that you wouldn't be paying interest on the full notional of the trade, only the actual margin borrowing amount.)

The underlying question here is, do you have any clue about Chinese bank bonds, or are you just doing this because the bank tells you to? The only reason you're considering this trade is because the bank said "look, here is a Trade, look at this huge yield on the Trade, would you like to buy a Trade?"; I'm going to go out on a limb and guess that you don't actually have any view on the creditworthiness of Chinese banks. That's a terrible reason to put the trade on; you're just taking whatever the bank stuffs down your throat.

If the bank really thought that Chinese bank bonds were a good investment, they'd be keeping those bonds for themselves. They're not offering you this trade because they think it's a good trade; they're offering you this trade because they think it's a bad trade and they want to offload the bonds.