Overcoming the bias for corporate issuers to lock-in low fixed-rates.
The demand for duration continues to enable corporates to issue long bonds of 30 years or more despite rising expectations for a US rate hike. As the Wall Street Journal highlighted August 5, investor appetite for 30- to 50-year bonds has pushed yields down, and issuers are responding with long bonds. There are also plays on different yield curves with McDonald’s selling a 40-year £300 million issue in June (4.125 percent) versus Caterpillar’s 50-year $500 million offering in May (4.75 percent).
But while it’s an understandable impulse to lock-in low rates out as long as possible, it needs to be balanced against the asset-liability management (ALM) considerations and desired fixed/floating debt mix preferences. That ALM considerations are trumping rate expectations in market demand for long bonds indicates something about the prevailing wisdom. Thus, corporate issuers of long bonds need to think carefully about their impact on the more holistic rate exposure to the firm.
More than getting your fix
Discussions at the NeuGroup meetings in the first half of the year indicated that more corporates should actually be upping the floating mix of their debt. A survey of members showed many in the range of 70-80 percent fixed. Analysis aimed at optimizing interest-rate cost volatility would suggest that most corporates should be much less fixed, even the inverse, especially if they wish to match off high-level cash positions that tend to be invested in shorter-duration assets.
- Consider mixing in FRNs and CP. Given the rise in cost of swaps due to OTC derivatives reform (including collateralization), one suggestion was to accompany long-bond issues with a tranche of floating-rate notes or make use of commercial paper (as if anyone needed an excuse for this). This can help improve floating exposure in debt mix without swaps.
- Educate senior management and board. To overcome the fixed borrowing bias, and policy that institutionalizes it, several members suggested a strategy of board-level education using stress-testing and other illustrative examples to show long-run benefits of higher floating mix. Start with correlations of a company’s financial results to interest rates and how company results respond to the interest rate moves.
- Put in the context of ALM. Part of educating the board and senior management should be an initiative to get more sophisticated about asset-liability management, which tends to lag at non-financial corporates (more job one for banks). One member walked his group through an initiative to implement a more “adult” ALM approach for his firm, vastly upping its floating-rate exposure, and this resonated with many in the room.
- Be proactive. One banker noted that historically, five-year and ten-year swaps to floating have outperformed on average even during periods leading up to the start of a Fed hiking cycle. However, outperformance tends to decline as the start of the hiking cycle approaches. Therefore, it may be prudent to enter into swaps to floating sooner than later, given that the market seems to want to bring forward the Fed forecast of a first rate hike in mid-2015.
Corporate treasurers can still love the long bond, but be clear about the reasons for issuing one. It should be as much or more about meeting the demands of key investors’ ALM situation, and not necessarily your own.
Forward Swap Curve Out 50 Years
The chart below shows the forward swap curve for USD interest rates out the next 50 years, along with spot and spreads.