Managing interest rate risk on future debt issuances
Corporates | Kennett Square, PA
The ongoing upward trend in U.S. Treasury yields has many corporates concerned about interest rate risk on future debt issuances. To successfully hedge this risk, it is important to understand best practices concerning hedge structure and pricing.
- Between ongoing vaccine distribution, the latest fiscal stimulus, and dovish monetary policy, there is currently significant upward pressure on U.S. Treasury yields.
- Corporates should be aware of heightened interest rate risk associated with future fixed-rate debt issuances as the yield curve continues to steepen.
- Achieving the best pre-issuance hedging strategy requires an understanding of the credit, pricing, and hedge accounting considerations involved.
Trends in corporate issuance
2020 was a record-breaking year for corporate bond issuance, which grew by just over 60% compared to 2019. Most of the increase came in Q2 as corporates sought to grow their balance sheets in reaction to the pandemic. More recently, after a relatively quiet Q4, issuance rebounded to $181 billion in January 2021, marking the start of what many expect to be a strong year of economic recovery.
Bond market volatility
Given that debt issuances will typically price over Treasuries, volatility in Treasury markets can create uncertainty as to what rates corporate borrowers can achieve. There was significant movement in the 10-year Treasury at the end of February as a confluence of market factors led to a demand shortage and drove yields to their highest levels since before the pandemic. Optimism for strong growth in 2021, and associated fears of inflation, will continue to put upward pressure on Treasuries in the coming months.
Credit and pricing dynamics
When swaps are used to hedge future fixed-rate debt, they typically cash settle on the date of issuance, offsetting the fluctuations in value between hedge execution and issuance date. The cash settlement means that credit exposure does not extend all the way to the maturity of the underlying bonds, which limits the credit charge that corporates will face when entering into hedges. With that said, the full tenor of the swap (from issuance date to bond maturity) will make pricing highly sensitive in dollar terms. As a result, efficient execution is extremely important, especially for large issuances and longer tenors. The below table shows the associated dollar value of a 1 basis point (0.01%) change in swap pricing, per $100 million notional hedged. Even slight improvements to your negotiated credit charge and fixed rate can lead to hundreds of thousands of dollars in savings.
Hedge accounting considerations
Unlike term debt, there is typically some level of uncertainty around the future debt instrument, particularly regarding tenor and issuance date. Mismatches between the hedge structure and the eventual debt will impact both the economic and accounting effectiveness of the hedge. (For a detailed look at how hedge accounting plays into pre-issuance hedging, read "Pre-issuance hedging in today's market.")
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, and 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.21-0072
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