Opportunities as yield curve steepens at the short end and flattens further out.
The yield curve has been flattening at the long end for some time, but this year and especially the last few months the short end has steepen significantly, too. This is a trend that can provide opportunities for corporate treasuries, and insight into their priorities, both for liabilities and assets.
Corporates have issued debt in record volumes over the last several years to take advantage of historically low interest rates, and many are no doubt sated. For those that aren’t, though, a flattening yield provides inexpensive funding for longer periods.
“For those in the market to borrow money, a company thinking about three-year debt may be more inclined now to go out five or seven years, because now it costs less to go out further,” said Paul LaRock, managing director at Treasury Strategies, a Novantas company. “And better to do so sooner than later, [because] if enough people move in that direction,” that opportunity fades.
In fact, the spread between two-year and 10-year Treasuries actually widened September 15 to 0.97% from a low of 0.77% on August 30, a 26% increase. A year ago, however, the spread was 1.46%, and at the start of 2015 it was more than 2.5%, so even the recently steepening remains relatively flat.
Liz Minick, head of Bank of America Merrill Lynch’s transaction services team focused on large corporates, noted two working capital functions for which corporates are pursuing somewhat unanticipated paths – given the curve’s flattening in the medium and long term. For one, corporates have continued to increase their use of commercial card services, even though cheaper funding stemming from the flattening yield curve should, at least on the surface, reduce their interest in those programs.
“We used to talk to clients about getting a new card program or extending an existing one in order to extend their days payable outstanding (DPO), so it was a working-capital play,” Ms. Minick said. “Now it’s an efficiency play. They’re seeking to draw out expenses instead of extending payables.”
Similarly, the lower cost of debt would seem to lessen corporates’ interest in supply chain finance programs, in which buyers optimize working capital by seeking to lengthen payment terms to their suppliers and receive discounts from them for paying early. Large, highly rated companies tend to negotiate the lowest funding rates. They can thus extend their balance sheets to suppliers—typically smaller companies with less stellar credit—by offering financing at terms the suppliers would be unable to get otherwise.
“You would think that in a low-rate environment, a highly rated company wouldn’t need such a program,” Ms. Minick said. “But such programs are actually allowing them to take advantage of the low-rate environment and pass that benefit on to their suppliers.”
The very short end of the yield curve has instead steepened significantly, especially in the last few months, pushing three-month Libor up to nearly 0.86% September 15 from 0.65% in early July, a more than 30% increase in two and a half months.
From a funding standpoint, companies can take advantage of the steepening curve on the short end to fund their operations with low-cost short-term debt, although that carries risks if volatility increases and access to short-term debt becomes more difficult.
On the investment front, Ms. Minick said corporates continue to struggle to balance what to do with overseas earnings, since US tax policies make repatriating cash unattractive and negative rates have become prevalent in both Europe and Asia. And even riskier emerging-market countries have also lowered rates or are talking about it.
“If a company is making ‘X’ revenue offshore and the opportunity to do anything with those revenues becomes ‘Y,’ it leads the company to revisit its global growth plans and which markets to focus on,” Ms. Minick said.
The markets to which they’re turning tend to be in the US, which offers low but not yet negative rates, and in countries where rates are regulated such as China, Brazil and India, although repatriating funds from those jurisdictions can be difficult. In India, for example, companies can pull out money and move it around although certain rules must be followed, and while China remains restrictive, it has facilitated the use of cash pooling structures to enable the movement of cash outside the country. It’s very difficult to get money out of Brazil.
Another big factor impacting the yield curve is US prime money market fund (MMF) reform that will introduce measures to restrict redemptions and goes into effect October 14, 2016. The short end of the curve has steepened in part because of a dislocation in the market stemming from a reduction in demand by prime MMFs for some short-term assets such as commercial paper. Lance Pan, director of investment research and strategy at Capital Advisors Group, noted that the spread between a recent nine-month CP issuance by a Canadian bank and its three-year bond was only 13 basis points, a bargain given the Fed will raise rates sooner than later, reversing that trend.
That dislocation stems mainly from what Mr. Pan called the “theory of natural habitat,” which states that investors often have a mandate to invest within specified parameters. So when MMF reform prompted those funds to shift to government securities (which will not have gates, fees or a floating net asset value) and/or stop buying paper with maturities extending beyond October, other investors such as pensions and bond funds were unable to pick up the slack. The sudden drop in demand caused yields on that paper to spike.
Now higher quality CP from Fortune 500 companies and multinational banks can be purchased at prices comparable to bonds from those institutions with maturities of two years or more. Of course, that means either those corporates don’t face natural-habitat restrictions, or they can quickly persuade their corporate boards to adapt their companies’ investment policies. “Treasurers can go into the market place now and purchase high-value CP names,” Mr. Pan said.
He added that the cumbersome process to change investment policies as well as the volatility likely to arise from the Federal Reserve’s anticipated rate hike in December and the presidential elections make it unlikely that dislocation will fade before year-end.
Ms. Minick said BofA Merrill’s clients have spent much of the year revising or considering revisions to their investment policies, in order to look at investment alternatives to prime MMFs, but so far little action has been taken. “We definitely do see clients talking about doing more alternative investments, but so far I haven’t seen a company that never invested in CP doing so,” she said, adding, “Although I have seen companies that have invested historically in CP doing more of that now.”