What a few weeks we’ve just lived through in the financial markets, with no shortage of turbulence, turmoil, and downright tribulation across the world. The S&P 500 tumbled more than one hundred points last week, a dubious distinction it had not achieved since the grim days of October 2008 – as of this writing, it’s fallen more than fifty points in a single morning. China’s yuan (partially) and Kazakhstan’s tenge (entirely) shifted to a freely floating currency from central management, causing the former to fall materially and the latter to plummet precipitously. A barrel of crude oil cost 32% less than it did at the outset of July.
Against this backdrop of coordinated devaluating pressure, it’s no surprise that market volatility measures have jumped considerably. 2-year cap volatility, a measure of the cost of insuring against rising interest rates, has climbed 13% over the last month, while the implied volatility of S&P index options as calculated by the VIX has more than doubled. And though events of the last fortnight may shift the Fed from that target, many market participants have intimated that September would bring the first rate hike in nine years.
With so many harbingers for increased turbulence ahead, New Jersey’s decision to unwind all of its interest rate hedges came as no small surprise. The state had over $4 billion of municipal bonds hedged with swaps, and it paid around $720 million to terminate them early. As a consequence, New Jersey will no longer have any protection against rising interest rates, fully bearing their cost.
As we read the coverage of the Garden State’s de-hedging decision, we couldn’t help but marvel at some of the language used to describe it. Among the more puzzling comments:
(1) New Jersey has ended its experiment with derivative contracts. Doubtless if we could interview the state treasurer and other officials who entered into the interest rate hedges in the middle of the last decade, they would not have described the swaps as “an experiment.” Perhaps they would have talked about locking in known borrowing rates for the state over the next 20-30 years, ensuring predictable debt service requirements throughout the economic cycle.
(2) [As background on municipal use of swaps] Detroit entered swaps on pension debt, but the city’s bet that interest rates would rise proved wrong. When entered into in conjunction with a floating rate borrowing, a fixed-rate swap should never be thought of as a bet; in fact, it is bringing greater certainty to a previously volatile situation, the opposite of what bets do. Should we also say that any municipality that leaves floating-rate debts unhedged is betting that interest rates will stay low?
(3) The state cleaned up its balance sheet. It’s true that the New Jersey balance sheet will no longer have interest rate swaps as a line item. Swelling the balance sheet in their place will be bond issuances, made all the larger by the decision to crystallize the liability value of the swaps.
(4) The state removed a big, unpredictable liquidity risk. Had credit downgrades happened – ratings-agencies were reputedly circling New Jersey – swap counterparties could potentially have been able to terminate the swaps or require collateral. By preemptively terminating the swaps on a negotiated basis, the state could perhaps avoid a sudden demand for liquidity should they be forcibly terminated. However, now that this particular liquidity risk is off the table, unbounded interest rate risk takes its place. With rates hovering just above zero, any rate rise will bring commensurate higher borrowing costs and no compensating reduction in hedge payments.
The case of oil producer Continental Resources may prove instructive. Last year, as disclosed with their Q3 2014 results, the firm elected to cash out of all of its oil hedges through 2016, reaping a one-time gain – from June to early November, WTI prices had fallen from $105 to $80 per barrel, making these hedges considerable assets. Betting that oil would rebound in the face of OPEC’s “toothless” approach, the firm sold off its protection for the next two years, giving up a certain cash flow for a variable one. But as of this morning, the price of one barrel of crude oil now stands below $40 per barrel; through the end of 2016, the firm no longer has any downside protection on the price at which it can sell, meaning the gamble to terminate all its hedges early has cost it tremendously.
While extenuating factors both positive – appreciated asset sale – and negative – ratings downgrade – may motivate an early hedge termination, there are substantial risks associated with removing rate or price protection, especially in an exceptionally volatile market. If you are considering any changes or additions to your hedging situation, please don’t hesitate to give us a call.