Hedging future fixed-rate debt
Corporates | Denver, CO
SummaryMany organizations are taking advantage of low long-term rates by locking in rates on future fixed-rate debt issuances. Companies pursuing this strategy should be prepared to navigate the complexities of trade structure, accounting, and market pricing for this approach.
- Corporate bond issuance levels are up over 80% compared to the first half of 2019 and long-term rates continue to hit all-time lows.
- This dynamic has triggered interest from many corporates to lock in rates on future fixed-rate debt issuances.
- 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.
With corporate bond issuance levels up over 80% compared to the first half of 2019 and long-term rates continuing to hit new all-time lows, many corporates seek to lock in rates on future fixed rate debt issuances. While some companies issue debt routinely with standard hedging practices in place, many find themselves exploring this topic 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 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.
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.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0335
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