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Fixed-To-Floating Interest Rate Swaps Paired with Long-Term Debt Issuance

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Fixed-To-Floating Interest Rate Swaps Paired with Long-Term Debt Issuance VOLUME NO. 12 FLOATING RATE STRATEGIES THE CHALLENGE FOR LONG-TERM DEBT ISSUERS Fixed-to-floating interest rate swaps Companies use the public and private senior debt markets to build a strong long-term paired with long-term debt issuance capital base. Since investors in these markets are generally fixed rate investors, the debt is a classic combination for debt instruments created are usually fixed rate. This means that even though an issuer’s managers seeking long-term finan- optimal rate management strategy may not call for more fixed rate exposure, the term cing at low cost. When the yield debt issuance process overweighs the issuer’s rate sensitivity towards fixed rate curve steepens, as it has recently in exposure. both the U.S. and Canada, strategies for converting fixed rate debt to Fixed-To-Floating Interest Rate Swaps floating rate become even more Companies use fixed-to-floating interest rate swaps to correct this imbalance. With the attractive. This issue of Derivations exception of the most highly rated issues, it is rare that fixed rate debt can be swapped at issuance to floating rate at levels comparable to rates on the company’s commercial describes several strategies that paper or floating rate bank debt. For this reason hedgers tend to defer the repair of rate fixed rate debt issuers can use to sensitivity ratios until market conditions for the swap are more attractive; i.e. when take advantage of the widening gap long-term interest rates rise and the yield curve steepens. between short- and long-term interest rates. As the graphs below illustrate, since October 1, 1998, long term U.S. Treasury rates have increased by more than 1 full percentage point. Moreover, the spread between long and short-term rates (e.g. between 6 month Libor and the 10 year swap rate) has widened from 6 basis points (bps) on October 1 to almost +100 bps today. In this improved environment, converting recent fixed rate debt issues to floating becomes a more viable strategy. Term Rates Trend Upward 10 Year Swap Rate October 1998 – March 1999 6.25 % Canada 6.00 % U.S. 5.75 % 5.50 % Interest Rates 5.25 % 5.00 % Oct-98 Nov-98 Dec-98 Jan-99 Feb-99 Mar-99 Timeline Yield Curve Steepens October 1998 – March 1999 1.25 % Canada 10 Year Swap – 1.00 % 3 month B.A.’s 0.75 % U.S. 10 Year Swap – 0.50 % 6 month LIBOR 0.25 % Percentage Points Percentage 0.00 % -0.25 % Oct-98 Nov-98 Dec-98 Jan-99 Feb-99 Mar-99 Timeline The graph below shows where fixed rate debt swaps to floating in today’s market (March 1999). At these levels, the floating spreads on swapped long-term debt are more attractive for many companies than directly issued short-term debt. Low Spreads on Swapped Fixed Rate Debt Where 7% Fixed Rate US$ Debt Swaps Today March 1999 1.2999881.30 %% Libor + 1.25 % 1.2499881.25 %% 1.1999881.20 %% 1.15 % 1.1499891.15 %% 1.0999891.10 %% 1.0499891.05 %% 1.02 % 0.9999901.00 %% 0.9499900.95 %% 0.90 % 0.899991 Points Spread in Percentage 0.90 %% 0.8499910.85 %% 33 YearsYears 55 YearsYears 77 YearsYears 1010 Years Timeline Forward Starting Swaps When the yield curve steepens, long-term rates move up faster than short-term rates and forward interest rates move up even faster. Hedgers take advantage by committing to forward starting swaps instead of swaps that start immediately. For example, committing to receive a fixed rate of 7% for 10 years starting in two years lowers the floating rate on the swapped debt from Libor + .90% to Libor + .75%. The longer the start of the swap is deferred, the lower the floating rate spread. Short-Term Options On Swaps Short-term options on swaps offer a way to lower funding costs today while creating the potential for even lower cost floating rate debt in the future. This strategy is the liability manager’s equivalent to the “covered call writing” strategy used widely by investors and portfolio managers to generate increased asset yields. A typical written option strategy calls for the debt manager to establish a floating rate spread objective that is tighter than that available in today’s market. With that target in mind, the hedger then gives a bank the right to trigger a fixed-to-floating interest rate swap that meets the hedger’s more aggressive price. For this right, the bank pays a premium today. While there is no guarantee that the debt will actually be swapped to floating rate, the premium payment from the bank to the hedger provides a substantial financing cost subsidy whether or not the swap takes place. For example,1 a company with 7.00% term fixed rate debt and a normal floating rate target of Libor + 125 might tighten its floating rate target to Libor + 110 and commit to enter into a 3 year fixed-to-floating swap at its bank’s option on or before December 31, 1999. The option would generate premium income today of about 50 basis points, reducing this year’s funding costs by a like amount. If the bank elects to start the swap on 12/31, the company’s fixed rate debt converts to floating for 3 years at Libor + 110 bps (15 basis points below its usual floating rate spread objective). If the bank decides not to exercise the option, the liability manager restarts the cost-reducing covered option writing process all over again. Options On Long-Term Swaps While short-term options exercisable into short-term swaps have good value, options on long-term swaps have considerably more. For example,1 the same borrower might consider giving the bank the right to trigger a 10 year 7% fixed / Libor + 100 bps swap on December 31, 1999. This option carries a premium of 1.60%, worth $400,000 on $25 million in financing. Factoring in the premium value produces the equivalent of floating rate funding for the next year at Libor+ .40% (110 bps below the borrower’s usual floating rate target). If the right to swap is exercised, the debt against which the option is written converts to floating at 50 bps inside the company’s normal floating rate target. SUMMING UP Corporate debt managers constantly strive to balance liquidity needs against the cost of financing. Simple fixed-to-floating interest rate swaps (both spot and forward starting) as well as options on fixed-to-floating swaps, are tools that aid debt managers in finding a cost-effective equilibrium. 1 Rates are for illustrative purposes only. Actual rates quoted by a bank at anytime will vary depending on various factors. This material is for general information purposes only and is not to be relied on as investment advice. Readers should consult their own financial advisors before making any investment decisions. © Copyright Bank of Montreal 1999.
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