Pre-issuance hedging in today's market
Corporates | Kennett Square, PA
Corporates | Kennett Square, PA
SummaryJumping almost 20 basis points in the first week of the new year, higher 10-year Treasury yields and a general steepening of the yield curve have galvanized the pre-issuance hedging discussion for many corporates.
For companies expecting to issue debt in the next few years, now may be the time to consider hedging the Treasury or floating component of any financing and understand the requisite strategy and accounting approaches.
While optimism abounds as the economy looks ahead to a post-pandemic growth cycle, the picture may be less auspicious for corporate borrowers who are seeing current rates and potential future rates at materially higher levels than during 2020. Even as the Federal Reserve and other global central banks have ensured that short-term rate hikes are years away, longer-term yields are indeed on the rise, reflecting the market’s expectation of future economic growth and eventual medium-term inflation. After ending 2020 at a yield of 0.913%, the 10-year Treasury climbed to as high as 1.183% on January 12, before retracing those gains in the weeks following, though remaining above the 1.000% threshold. On the growth side, the IMF remains sanguine about 2021 GDP growth, with a revised forecast of 5.1% YoY growth in the US. In tandem, the market is pricing in higher inflation expectations, evidenced by 5-year inflation breakevens rising over 2% for the first time since mid-2019. Amid the possibility of further yield curve steepening, it is important to understand mechanics and tradeoffs of pre-issuance hedging.
Product choice, structuring, pricing
When it comes to hedging a future issuance, the optimal hedge is one that best aligns with the underlying risk and prices efficiently while meeting the benchmark for accounting effectiveness. In some cases, a Treasury lock is the appropriate product. For this trade, the company executes a synthetic forward sale of the exact Treasury their bond will price off. The Treasury lock works best when certainty of issuance timing is high, and the time horizon is short (typically less than three months). The other most popular product is a forward-starting interest rate swap, which is a swap economically structured to match the anticipated issuance, but is cash settled upon issuance, resulting in an offset to how underlying rates moved. This product can introduce the basis between where Treasuries and swaps trade (often very small) but is highly liquid at longer tenors. Swaptions present a third alternative for companies who may seek risk reduction but are constrained from a credit perspective. For any structure, there are various considerations on the appropriate hedge ratio, execution dynamics, and pricing nuances that should be considered.
Hedge accounting considerations
Due to inherent uncertainties around future issuances of debt, there is typically an increased level of complexity associated with this hedging strategy, particularly with respect to notional, tenor, and issuance timing. In order to qualify for cash flow hedge accounting, management needs to contemplate these uncertainties in the upfront documentation and assess potential mismatches between the hedge structure and the eventual debt to confirm that the hedging relationship will be highly effective. If appropriate range of issuance dates or tenors were not contemplated at hedge inception, an unanticipated mismatch could cause the company to lose hedge accounting and recognize a significant earnings impact from the hedge.
LIBOR transition considerations
As of this writing, for forward starting swaps, most corporates are still hedging with LIBOR-based swaps, despite the anticipated discontinuation of LIBOR for new contracts beginning next year. The market for long-dated SOFR-based swaps is also available but currently is less liquid and offers more minimal data and market history for pricing and mechanics of those trades. In most cases, a LIBOR-based swap—which will now include the new ISDA fallback framework by default—have been the go-to product for long-dated pre-issuance hedging in the corporates space.
Chatham Financial Corporate Treasury Advisory and Hedge Accounting
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.21-0037
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