By John Hintze
There is growing concern among corporates that their companies’ existing debt will cost far more than anticipated to refinance if rates rise.
Some companies have parked a portion of their abundant cash in fixed-income and may be concerned about the impact of rising rates, but most firms are net debtors and are far more concerned about the cost to refinance bond issues at some point in the next few years, and how to hedge that risk.
Despite recent chatter that the Federal Reserve could start acting this summer, the consensus is that the central bank is unlikely to raise rates before 2014, or whenever the unemployment rate falls to 6.5 percent—the rate at which Ben Bernanke has said it could end quantitative easing. Still, strong economic growth or other unexpected factors could prompt the Fed to accelerate that plan, and recent reports about major institutional investors taking measures to mitigate rising-rate risk suggest concerns are building.
In addition, Morningstar recently reported that equity mutual funds and ETFs had seen the first significant inflows in years, a shift that has been accompanied by the stock market indices reaching new highs over the last month. In 2012, stocks saw outflows for five months, and inflows for each of the remaining months were less than $17 billion, but inflows shot up to $65 billion in January and $30 billion in February, according to Morningstar. Monthly bond inflows this year, meanwhile, have continued 2012’s average of about $30 billion.
Companies Still debtors
Some Treasury departments at big corporates, especially technology firms, are cash rich and investing heavily in Treasuries and venturing into riskier asset classes such as asset-backed securities. However, said Amol Dhargalkar, managing director of risk management services at Chatham Financial, most companies are net debtors.
“When [corporate finance executives] talk about interest-rate risk, it’s mainly how it will affect their cost of funds rather than their investment portfolios,” Mr. Dhargalkar said, adding, “At least that’s where CFOs, boards and treasurers are placing their emphasis, and how they’re measuring the risk they truly have.”
Mr. Dhargalkar said the discussion typically focuses on two areas. One is their companies’ existing, floating-rate debt that will result in a higher cost of funds as rates rise. And the second is refinancing their fixed-rate debt they’ve taken on recently at rock-bottom rates a few years down the road, when rates may be significantly higher.
tools at the ready
A variety of tools are available to hedge those risks, such as inverse ETFs, swaps, futures and put options, but many of them may hedge only most of the risk, not all.
“The more closely you can align your risk mitigation strategy payoff with the adverse consequences, the better—certainly from a cash standpoint,” Mr. Dhargalkar said, noting that a strategy that covers 80 percent of the risk may be less costly, but explaining why the hedge didn’t work to the company’s board is not a conversation a treasurer want to have. More precise hedging also enables public companies to use hedge accounting to lessen volatility in earnings.
Wall Street’s tools, however, all carry a price. And if rates rise only gradually, that price may be unwarranted. David Land, a portfolio manager at Advantus Capital Management, noted that GDP growth in the 1950s and 1960s averaged about 4.1 percent, dropping to 3.2 percent over the next 20 years, and to about 2.5 percent since 1990. Other factors such as higher unemployment rates compared to previous recoveries and lagging job creation suggest the Fed will have no urgency to hike rates significantly. Indeed, the current U.S. economic situation resembles Japan’s slow growth period in the 1990s.
“Our view is that rates stay around this level until the unemployment rate drops to 6.5 percent, and then rates may move up, but we don’t think it’s going to be horrific,” Mr. Land said.
The move to higher rates could gain momentum faster than the market thinks.
Markets, however, don’t always follow analytical conclusions, and any number of unanticipated factors could push rates up, fast and furious. Jim Schaberg, a managing director at agency brokerage Incapital, which specializes in corporate bonds, noted that the bond market has seen a remarkable decade of returns, and market psychology can be anything but logical.
“When the move to higher rates begins, it could gain momentum faster than many market participants assume,” Mr. Schaberg said, adding, “If a big manager sees a mass exodus of its bond fund holders, and it has to keep a certain amount of cash in its funds…that I think is a real risk factor.”
10-year treasury too low
Robert Johnson, director of economic analysis at Morningstar, said the 10-year-Treasury rate historically runs about 2 percent above inflation, and so it should be upward of 3.8 percent today, instead of the current 1.88 percent. He sees the rate quickly jumping to the higher level as soon as it becomes apparent the Fed is easing off its quantitative easing policy. A 1 percent jump would result in a 8.89 percent loss in principal on 10-year Treasuries and a 19.3 percent loss on the 30-year. On the plus side, Johnson doesn’t see the 10-year rising above 4 percent.
“[The rate increase] will shock the market, and stocks and bonds will bleed for about a week, but then it will be done. I don’t think rates are going above 4 percent,” Mr. Johnson said.
If so, corporate issuers have a variety of choices at their disposal. Mr. Dhargalkar said the most common trend his firm has seen among corporates is simply swapping to fixed-rate debt from floating-rate, thereby cementing interest payments at historically low rates. In addition, companies planning to issue debt in anywhere from several months to a few years in the future, he said, are increasingly looking to forward-hedge those anticipated bonds, typically by using an interest-rate swap to lock in a future rate.
“You’re almost taking the view that your cost of funds will be highly correlated with the swap rate itself,” Mr. Dhargalkar said.
If the 10-year swap rate today is 2 percent, for example, a company may be able to lock in a swap rate two years from now at 2.7 percent, because rates are expected to rise, plus some borrowing spread. If the swap rate instead rises to 3.7 percent by March 2015, the treasurer is viewed as prescient and the company receives a big payment upfront on that hedge of 100 basis points per year, multiplied by 10 years at the present value back to today, and that offsets the higher rate at which the bonds are issued.
If the swap rate instead falls to 1.7 percent, the hedge becomes a liability and the company must make payments. However, that’s offset by its ability to now issue bonds at a rate of 1.7 percent plus the borrowing spread.
“If you size and enter into the transaction correctly, and it’s very nuanced, the net of the cash settlement of the hedge and the increased or decreased coupon you pay should be equivalent to one another,” Mr. Dhargalkar said.
Nevertheless, swaps commit the user to the initially locked in rate. Swaptions, instead, allow users to back out of the commitment as well as take a view on which way rates will go and how far, and potentially profit. It is unusual for typically conservative corporate treasuries to engage swaptions because of their added risk, and because their upfront premiums tend to be expensive, and they tend not to be eligible for hedging accounting treatment.
Markets don’t always follow analytical conclusions, and any number of unanticipated factors could push rates up, fast and furious.
Mr. Dhargalkar said protecting interest expense beyond a 2.7 percent rate on the 10-year swap rate in two years would now cost upward of $4.5 million per $100 million hedged. If rates stay below 2.7 percent, that upfront premium is lost. However, if rates rise to 3.7 percent at the two-year mark, the user receives the 1 percent per annum difference between the actual rate and the strike price, or approximately 8.2 percent of the principal amount. However, this must be netted against the upfront premium to determine the overall effectiveness of the strategy.
Mr. Dhargalkar added that the cost of two-year protection today using a swaption that goes out 10 years is about half of what it was shortly after Lehman Brother’s collapse in fall 2009, and down 5 percent to 10 percent from a year ago. “That’s a meaningful drop from last year, but not enough to change the calculus of most of our clients,” Mr. Dhargalkar said.
The swap rate, on the other hand, has dropped much more significantly. Five years ago, before the financial crisis and meltdown of several large banks, the three-year swap rate was above 4 percent, and on April 2 it was 52 basis points, indicating the three-month LIBOR rate is going to average that level over the next three years. Viewing the 10-year horizon, the 10-year swap rate five years ago was approaching 5 percent, and today it is around 2 percent, a significant if less dramatic drop compared to the three-year swap rate.
The three-year swap rate reached a low in December of about 40 basis points, and so it has risen by about 25 percent since then, although only 10 basis points. More significantly, the 10-year swap rate’s lowest point in 2012 was about 150 basis points, so it has risen by a third.
“Fifty basis points is a significant enough increase…to signal that if not over the next three years but sometime over the next 10, we can expect rates to rise meaningfully,” Mr. Dhargalkar said.