Hedging future fixed-rate debt
Chief Operating Officer
Corporations can take advantage of the current rate environment to reassess their interest rate exposure. Locking in rates on future fixed-rate debt issuances can be particularly advantageous because of the current inversion in the forward curve, heightened volatility in yields, and substantial global market uncertainty.
The volatility in the interest rate markets and ongoing uncertainty regarding the potential for a U.S. recession is causing many corporations to re-assess their interest rate exposure. Questions around the expected path of inflation and timing of Fed rate adjustments are resulting in magnified day-to-day movements in interest rates. In August 2023 alone, the 10-year U.S. Treasury Yield moved from 4.0% to its highest level since 2007 at 4.33%, before falling again to 4.10% by the end of the month. Swapping floating-rate debt to synthetic fixed-rate debt or locking in rates on future fixed-rate debt ahead of issuance are hedging strategies that corporations can consider in order to reduce interest rate risk in the face of volatility and future uncertainty.
Today’s forward curve reflects the ongoing possibility that the Fed could still hike rates before 2023 ends; beyond that, the curve becomes steeply inverted beginning in May 2024. As a result, the fixed rate that can be locked in to hedge a forward period in time is lower than a spot starting rate that can be locked in today. Since swap rates reflect the market’s expectation of where interest rates are headed, executing swaps today allows a company to lock in the current rate cuts that the market is projecting.
These dynamics have triggered interest from many corporates to lock in rates on future fixed-rate debt issuances today. Companies pursuing this strategy should be prepared to navigate the complexities of trade structure, accounting, and market pricing for this approach.
While some companies issue floating-rate debt routinely with standard hedging practices in place, many find themselves exploring the topic of pre-issuance hedging infrequently. The process includes many parallels to hedging shorter-term floating rate debt, but it contains a few meaningful differences that your organization should be aware of prior to hedging.
While hedges of future fixed rate issuances and term loan debt both typically include pay-fixed structures, debt issuance product selections, and hedge structures include a few meaningful differences. The first is that the debt issuance will typically price over Treasuries. This introduces a product choice trade-off between a Treasury Lock that is a closer match to the underlying exposure, and a cash-settled forward starting swap that introduces swap spread risk but offers greater flexibility and pricing efficiency. Other structure considerations can impact credit, pricing, and risk reduction.
Forward hedging instruments are designed to be cash-settled upon issuance of the debt instrument. Even though the ultimate maturity of the hedge will align with the future debt maturity, the bank’s exposure to corporate credit is limited to the mandatory cash settlement date, which aligns with debt issuance rather than maturity. This reduces credit exposure and should reduce credit charges accordingly.
Despite the shorter credit exposure horizon, the underlying hedge instrument will typically have a longer-dated maturity than a hedge of term or revolver debt. This can drive a materially larger dollar value of each basis point on the rate, increasing sensitivity to pricing efficiency. Transparency into live market pricing as well as any trading, liquidity, and/or credit charges is especially important when the value of even a fraction of a basis point is material. This sensitivity is compounded by the fact that forward hedging requires not one, but two pricing exercises, including both the initial trade execution as well as the termination pricing upon debt issuance.
Unlike term debt, there is typically some level of uncertainty around the future debt instrument, particularly with respect to tenor and issuance date. Mismatches between the hedge structure and the eventual debt will impact both the economic and accounting effectiveness of the hedge. Both can be evaluated prior to hedging in order to structure the trade economics and accounting designation approach appropriately to maximize effectiveness.
If hedging a future fixed-rate issuance with swaps (as opposed to Treasury locks), your organization will enter into a swap where you pay a fixed rate and receive SOFR, the trade being cash-settled upon issuance of the fixed-rate debt. Standard market convention is to structure the swap with annual interest periods, indexed to SOFR compounded in arrears with no lookback and a 2-day payment delay. Although, specific terms can be customized based on the company’s preference.
As your organization continues to evaluate future debt issuances and seek hedging for longer horizons, you will need to navigate the complexities of forward hedging. Chatham provides access to leading practices related to trade structure and accounting as well as market pricing to ensure an efficient and effective hedge.
Chatham Financial corporate treasury advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of solutions includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.23-0126
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