Emerging Market Sovereigns’ Use of Total Return Swaps Raises Risks
Total return swaps (TRS) have been used in a small but growing number of sovereign transactions as a source of external financing in emerging markets, but while they can offer liquidity benefits, they also raise transparency and structural risk concerns, Fitch Ratings says in a new report.
The report noted that total return swaps can provide sovereigns hard-currency liquidity and funding flexibility, but limited disclosure weakens transparency and oversight.
In these structures, the report said sovereigns transfer bonds to a counterparty in exchange for hard-currency financing, functioning in practice as collateralised funding instruments.
Fitch treats pledged collateral as a contingent liability rather than debt unless it crystallises, revealing that Angola, Nigeria and Senegal have used or announced plans to use TRS, though their motivations differ.
Angola’s initial transactions reflected severely constrained market access, while Fitch believes later Angolan and Nigerian deals are more focused on funding diversification and liquidity management.
In Fitch’s view, Senegal’s case differs most, appearing more closely tied to lowering financing costs and limiting disclosure during a period of market stress.
TRS can provide access to hard-currency liquidity in difficult market conditions and may lower borrowing costs relative to conventional issuance.
However, contractual terms, including pricing, margin call thresholds, and termination provisions, are often not publicly disclosed, limiting legislators’ and market participants’ ability to assess the true cost and scale of sovereign borrowing.
Fitch said beyond disclosure concerns, the structure carries procyclical risks. When pledged assets are the sovereign’s own bonds, collateral values weaken as credit stress rises, meaning margin calls or early termination can generate unplanned hard-currency demands when liquidity is already under pressure.
The report acknowledged that there is no established precedent for how TRS would be treated in a sovereign restructuring, and their derivative form and limited disclosure create material uncertainty, with the risk for conventional bondholders appearing mostly negative given the potential for debt dilution as contingent claims crystallise.
For Angola, implied recovery for unsecured bondholders remains within the RR4 range at the current exposure level, Fitch said. South African Rand Strengthens Ahead of Inflation
