Coronavirus impacts on future debt issuances

March 9, 2020 Kevin Jones

Markets began 2020 on an incredibly volatile note, driven most recently by increasing concern over a possible global pandemic of COVID-19. While equity market drops grabbed the headlines, treasury professionals closely watched as U.S. Treasury yields plummeted to all-time lows at the 10- and 30-year tenor, dipping to 0.499% and 0.885%, respectively (as of March 9 mid-day). On the 10-year yield, rates have now fallen 113 basis points since February 12 as a result of global growth concerns and elevated potential for the Federal Reserve to cut short-term rates leading to a lower long-term target rate. While volatility has reduced some capital markets activity, firms continue to see attractive long-term rates in the bond market. Treasurers can take advantage of this even lower-rate environment by swapping floating rate debt to fixed and hedging future debt issuances out as far as two years.

Navigating product selection

If you wish to benefit from this low-rate environment, you must navigate many nuances of hedging future issuances, including product selection, pricing, and accounting treatment. Specifically, you must decide between treasury-based hedges and swap-based hedges. Treasury-based hedges, such as treasury locks, may better align with your firm’s specific issuance risk, particularly for investment-grade companies. Swap-based hedges however, such as forward-starting swaps, offer far more flexibility should anticipated issuance dates become delayed. Additionally, while short-dated (under three-to-six months) hedge pricing may favor treasury locks, hedging longer term with treasury locks may cost significantly more than using forward-starting swaps due to market structure.

Applying accounting treatment

Accounting treatment on pre-issuance hedges can also pose challenges. If applied correctly, gains and losses on these hedges can be amortized over the life of the hedged debt, allowing for smoother earnings. Unfortunately, qualifying for this type of hedge accounting treatment can be challenging depending upon your level of certainty over timing, tenor, and quantum of debt issuance. In the worst case, improper structuring of the hedge may lead to a missed forecast under hedge accounting — bringing your firm closer to becoming ineligible to apply this treatment at all.

Locking in lower rates

Despite these challenges, companies elect to hedge future issuances for two primary reasons: low prevailing rates and affordable pricing. For example, today’s 10-year treasury is 0.499%, and a firm can lock in a 3-month forward rate on the 10-year treasury at 0.481%, representing a 1.8 basis point drop in the yield. While during traditional periods where the yield curve is upward sloping you would normally see a positive spread between today’s rate and the forward rate, the inverted yield curve enables you to lock in a lower rate today for a future issuance. In fact, the forward premium to hedge future issuances is at or near all-time lows across a broad spectrum of maturities. As shown in the chart below, in the last few years this premium has been as high as 10-12 basis points, though is negative in the current environment.

The bottom line

Current markets present unique opportunities to lock in low rates on future financings. As quickly as rates have fallen, they may rise just as quickly with the development of a COVID-19 vaccine and measures implemented to slow and stop the spread of the virus. Chatham is ready to help you think through the implications of the current market conditions on your future financings. 

Chatham Financial Corporate Treasury Advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services 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.


Disclosures

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. 20-0052

About the Author

Kevin Jones

Kevin is a member of Chatham’s Corporate Treasury Advisory team, where he advises clients on interest rate and foreign currency hedging strategies. Kevin serves clients in numerous areas including risk quantification, hedging strategy development, and trade execution. Prior to joining Chatham, Kevin worked for the Federal Reserve Bank of New York, where he specialized in foreign central bank FX reserve activity and U.S Treasury markets. He earned his Bachelor’s degree in international business from James Madison University and earned his Master’s degree in Economics from Virginia Commonwealth University.

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