Interest rate risk pushes new multinational hedging strategies.
Hedging Floored Term Loan Debt
In the historically low rate environment of the last several years investors clamored for yield protection, leading many multinational companies to issue floating rate term loan debt with embedded floors based on the London Interbank Offered Rate (LIBOR).
With a floor on LIBOR, borrowers are unable to benefit from historically low rates today, in exchange for continued access to capital. LIBOR floors have become increasingly common within the higher yield (lower rated) part of the credit spectrum, ranging from as low as 0.75 percent to as high as 1.50 percent on LIBOR.
Some view this as being "hedged," reasoning that a LIBOR floor of 1 percent would imply that the cost of debt would not increase until LIBOR exceeds this level. But this view ignores the fact that the cost of debt increases when LIBOR exceeds the floor, resulting in one of the least effective "hedges" as it stops working when it is most needed, during rising rates.
The more effective solution involves the use of interest rate swaps, where the objective is to lock in interest expense regardless of the level of the underlying floating rate (e.g., LIBOR). In a typical vanilla swap, a borrower receives payments on LIBOR in exchange for payments on a fixed rate, where the LIBOR inflows on the swap from the swap bank to the borrower offset the LIBOR outflows on the debt from the borrower to its lending banks.
When a borrower it hedges floored debt with a vanilla swap, it introduces a new type of variability. Perhaps counter intuitively, as LIBOR decreases, the cost of debt actually increases because the swap is not compensating the company for the floor embedded into the financing.
For example, imagine a company borrows at a variable rate with a 1 percent LIBOR floor. Then imagine this company enters into an interest rate swap at a fixed rate of 0.75 percent. If LIBOR resets at 0.3 percent, the company must pay 1 percent to the lender but only receives 0.3 percent back from the swap counterparty. This represents a net loss of 70 basis points, in addition to the fixed rate that the company is paying on the swap (0.75 percent in this example) for a total interest expense of 1.45 percent.
The company's exposure is truly fixed only when LIBOR exceeds the floor, which oddly encourages the company to root for LIBOR to rise when it is below the debt floor. Where a multinational company's debt contains a LIBOR floor, it must purchase a second derivative--a LIBOR floor--and embed it into the swap in order to truly fix its interest rate. This will increase the upfront rate to 1.25 percent, in this example, but it truly locks in the cost of the financing under all scenarios.
Purchasing the floor is equivalent to purchasing an option on LIBOR, where the company has the right to receive the greater of LIBOR or 1 percent under the swap. The cost of the option is repaid over time in the form of a higher fixed rate: the difference between 0.75 percent and 1.25 percent in the example. This illustrates the incremental cost of hedging by embedding the floor into the swap.
Embedding floors and other options into swaps ultimately complicates the pricing and execution of the derivative. The process of pricing a swap with an embedded LIBOR floor involves three key steps:
1.) Calculating the vanilla swap rate;
2.) Calculating the value of the LIBOR floor; and
3.) Increasing the vanilla swap rate by an amount sufficient to compensate for the value of the floor.
This requires access to real-time valuation models that can calculate expected LIBOR rate settings, market volatility and discount factors. Ultimately, the rate on a floored swap will be higher than that of a vanilla swap because the value of the floor must be factored into the all-in swap rate.
Swaps with embedded floors also present accounting and reporting challenges.
Many publicly listed multinationals apply cash flow "hedge accounting" under Accounting Standards Codification (ASC) 815 (formerly Financial Accounting Standards Board SFAS 133), electing to defer changes in the mark-to-market value of their derivatives to the other comprehensive income (OCI) account, rather than let them flow through to earnings as other income or expense.
The benefits of applying hedge accounting are meaningful and generally outweigh the costs, especially for earnings-oriented publicly traded companies, where the CFOs can appreciate the benefit of reduced earnings volatility. Companies will need to consider a variety of factors to ensure that a given hedge can qualify for preferential treatment under the rules, including that the key terms of the debt and hedge match.
Beyond this, companies should consider building flexibility within their hedge documentation to minimize earnings volatility in the event there are any meaningful changes in the debt. Generally, achieving maximum flexibility on complex derivatives requires high sophistication on the companies' part, but the benefits can be quite significant as well.
Optimal Currency of Debt
Multinationals typically scour the globe for financing opportunities but have found it incredibly challenging to raise debt in the eurozone over the past several years. The crises that have beset Greece, Portugal, Ireland, Italy and others have shut many corporate borrowers out of the debt markets as investors have swung from optimistic to pessimistic on the common currency's future, sometimes even on a week-by-week basis. Many of these companies have had to search for access to capital markets outside Europe, though this may be far from optimal given the nature of the company.
This search for an optimal debt capital structure can lead to many conversations about concepts, such as optimal credit rating, cyclicality of businesses and investor diversification. From a currency standpoint, the concept of optimal debt capital structure may be somewhat simpler: can issuing debt in certain currencies reduce the company's currency risk?
Take the simple case of a company (let's call it ExportCo) with manufacturing expenses in U.S. dollars, revenues in euros and a maturing bond issued in euros. ExportCo's cash flow benefits when the euro strengthens against the dollar (e.g., the euro goes higher, from $1.30 to $-1.40 per euro), assuming it is unhedged.
As ExportCo explores ways to address the risk of another euro meltdown scenario, its preference would be to issue debt in euros for two main purposes. First, euro-denominated debt service will help ExportCo soak up excess euro cash flow that it otherwise would have to hedge to make dollar debt payments.
Second, euro debt will act as a hedge to the overall enterprise value of ExportCo itself in the form of the debt principal repayment. In other words, as the euro weakens, not only will revenue and consequently earnings before interest, taxes, depreciation and amortization (EBITDA) or earnings suffer, but the amount of dollars required to repay the euro debt also will decline. While far from a perfect "enterprise value" hedge, the euro debt does provide sonic mitigation to equity investors in ExportCo.
Unfortunately, with debt markets uncooperative in Europe, ExportCo is forced to issue fixed-rate bonds in the U.S. market at a rate of 5 percent. Now, ExportCo has a choice either to hedge the risk or not hedge, and prudently chooses to hedge its risk of euro depreciation. After considering a number of alternatives, the CFO decides to utilize a cross-currency swap to hedge its exposure.
Cross-currency swaps are complicated derivative instruments that require a deep understanding of multiple nuanced markets. Typically, cross-currency swaps operate in three stages: an initial exchange, interim payments and a final exchange.
In the initial exchange, ExportCo trades U.S. dollars from the bond offering with its bank counterparty in exchange for euros, which ExportCo will use to repay its maturing legacy euro bond. ExportCo proceeds to make interim payments in euros to its bank counterparty in exchange for dollar payments that match the debt service on the 5 percent dollar-denominated bond.
Then, in the final exchange, ExportCo reverses the initial exchange, paying dollars (in the amount its bank counterparty paid during the initial exchange) to its bank counterparty in exchange for euros (in the amount ExportCo paid its bank counterparty during the initial exchange). The illustration on page 46 provides a visual representation of these three peices, along with the net impact of the 5 percent dollar-denominated bond.
In essence, ExportCo has converted its dollar-denominated bond into a synthetic euro bond: initial proceeds, debt service payments and the final repayment of the bond are all now in euros, and, as a result, ExportCo has divorced the currency decision from the debt issuance process by overlaying a derivative on its debt to create its optimal debt capital structure.
Evaluating Suitability of Cross-Currency Swaps
Companies must invest meaningful time and energy to evaluate the suitability of cross-currency swaps (or any derivatives) for their risk profiles. At a minimum, four key factors typically impact the applicability of such transactions:
PRICING. What does the 5 percent dollar-denominated bond convert into on a euro basis? Could the company actually issue euro debt at a lower cost? If so, would it be better to simply do so, rather than develop and implement a derivative strategy?
Ultimately, the pricing of a cross-currency swap is determined based on the interest rate differentials between two currencies, meaning companies cannot engage in arbitrage by borrowing in dollars and converting to high-yield currency, like the Brazilian real. Additionally, complicated factors like cross-currency basis swap markets can have a tremendous impact on the ultimate pricing, increasing or decreasing favorability by 50 or even 100-plus basis points per year.
CREDIT. Bank counterparties take on tremendous risk in facing companies like ExportCo in derivatives transactions. Primarily, the risk comes from the final exchange, which is nothing more than a forward contract. For ExportCo, the final exchange is locked at 1.30 euro to the U.S. dollar, and should the euro strengthen over the life of the hedge, the final exchange will be a liability, as ExportCo could have sold euros and bought dollars at a more favorable rate, say 1.50 euros to one U.S. dollar.
The bank faces the risk that ExportCo will be unable to pay the difference in value, causing the bank to charge a return in addition to the market exchange rate for the transaction. Especially with global regulatory requirements impacting banks, these credit charges can add between 25 and 100-plus basis points per year to the cost of the transaction.
FINAL EXCHANGE. Is the final exchange necessary? How critical is it to hedge the enterprise value of the company? At maturity, ExportCo can simply net settle the final amount based on the difference between the locked rate and the then-current exchange rate; but this can have a tremendous cash impact, and if the transaction is a liability, the liquidity impact can be enough to create a crisis.
ACCOUNTING. Once again, under ASC 815 (FAS 133), the rules and requirements for treatment of such derivatives are challenging but not impossible to apply. Companies must consider the functional currency of entity in which the debt and hedge were issued, the nature of the different legs of the cross-currency swap and how its effectiveness will be tested on an ongoing basis.
All of this must be documented pre-trade: when done correctly, this allows the company to defer gains and losses appropriately such that the income statement is not distorted. If done incorrectly, cross-currency swaps can add significant volatility to a company's bottom line.
In recent months, strong equity and credit markets have driven a refinancing boom among multinational corporate borrowers, with recent changes in tone from central banks across the world further leading CFOs to focus on managing future interest expense. Historically, the transactions discussed herein were utilized only by large Fortune 100 companies. But over the last five years, as market forces have rendered financing decisions increasingly complex, these types of transactions have become more common in the middle market.
In particular, the financial crisis contributed to companies' designing and implementing derivatives strategies to support more complicated and often sub-optimal financing decisions. Though these trends have complicated optimizing a company's capital structure, they have not rendered it impossible when approached holistically and with knowledge of and experience with all of the dynamics at play.
Amol Dhargalkar is managing director of risk management services at Chatham Financial.
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|Date:||Sep 1, 2013|
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