White paper says otherwise rising rates will eat into reform’s corporate tax cuts.
The Federal Reserve’s anticipated rate increases will likely erase much of the earnings corporates gain from recent tax cuts, an outcome that could be lessened by applying forward-starting hedges soon.
Approximately 40% of US corporates’ $7 trillion in overall debt is floating rate, and as rates continue to rise, so will their interest payments. Many corporates initially swapped their floating-rate revolving-loan facilities and other floating-rate debt to fixed-rate in recent years to take advantage of historically low rates. However, if borrowers plan to roll over those loans, those exposures will see a significant jump in rates when the hedges end at loan maturity.
Inevitable Results
In a recently published white paper, Peter Seward, GTreasury vice president of market development and risk, described that “inescapable” conclusion and argued that now is the time to start assessing and planning for hedging the future rolling of loan facilities. “The corporate world is facing this reality, and 40% of their debt should go through this type of analysis,” Mr. Seward said in an interview.
The paper notes that Libor, the benchmark used to price most floating-rate debt, carefully tracks the short-term fed funds rate that the Federal Reserve will most likely increase several times by the end of next year. The paper then describes a hypothetical three-year, $500 million floating-rate revolving facility that was originated early in 2017, matures at the end of 2019 and is 80% drawn. Assuming the existing exposure was hedged, the paper assesses four possible outcomes should a forward-starting interest rate swap be put in place to hedge the debt after it rolls over next year:
- Market—Current rate; the benchmark.
- Market +1%—Libor rises 100 bps.
- Yield curve inversion—Shorter-term rates rise faster than long term.
- Credit crisis—Rates jump to extreme levels seen during the credit crisis.
Mr. Seward noted that even with a hedge on the current facility, and without any further Libor increases between now and the end of 2019, when the loan and hedge mature, there will be an inescapable increase in the borrower’s effective rate.
“Depending on the view of what will happen in the next 18 months, the borrower could be paying anywhere up to 100 bps more if it doesn’t hedge, and it will have to pay that instantly when the currently hedged loan rolls over,” he said. However, entering into a forward-starting swap now lessens the pain later in most scenarios.
If the borrower’s rate stays at 4.5%, the benchmark, then that’s what the borrower will pay with or without a hedge (and ignoring the cost of the hedge). If the Fed notches up the fed funds rate by 100 bps by the end of 2019, thereby increasing the borrower’s rate to Libor to 5.5%, then applying the forward-starting swap now locks in an effective rate of 4.8%, a savings of 70 basis points.
Under the yield-curve inversion scenario, the Libor rate increases only slightly, to 4.65%, and applying the forward-starting swap drops the borrower’s effective rate to 4.6%. And lastly, under the credit-crisis scenario, the borrower will see its rate jump to 6.9% when the existing hedge expires, but with a forward-starting swap that drops to 5.9%.
“A 100 bps increase in rates, even after hedging, will effectively reduce that increase in after-tax earnings to 5%.” —Peter Seward, GTreasury
The report notes that under the inverted yield-curve scenario, if the inversion is associated with longer-term rates, then the benefit would be greater, and adds that the effect of hedging provides $3.5 million to $5 million in annual savings.
Tax cuts muted
The white paper also assesses the likelihood of each scenario using a cash-flow-at-risk analysis, and it finds that Libor plus 100 bps is the one to be most reasonably expected. Mr. Seward pointed to a recent Federal Reserve analysis that estimated such an increase in rates would reduce companies’ interest-coverage ratio overall to 4.1 from 4.6. He noted that will effectively eliminate about two-thirds of the recent corporate tax cut.
“The corporate rate was lowered from 36% to 21%, a 15-percentage-point decrease that provides a 15% increase in after-tax earnings. So a 100 bps increase in rates, even after hedging, will effectively reduce that increase in after-tax earnings to 5%,” Mr. Seward said.