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Capital Markets

Flush Corporates Look to Harness Future Low Rates

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September 08, 2016

Having optimized cap structures corporates look to extend low-rate benefits.

Bond3Historically low rates over the past several years have left most corporates’ capital structures in good shape, which has allowed them to move the issue down their list of priorities. Nonetheless, many are making moves to protect a good thing.

If anything, corporates have overindulged on low-cost funding and abundant liquidity, such that concerns are emerging that unexpected events resulting in a sharp rate increase and/or liquidity drying up could leave some of them in dire refinancing straights. For the most part, though, they’re in good shape capital-wise and with low rates looking like they’ll be around for a long time, some have been told they can wait to issue more.

An assistant treasurer of a major US consumer goods company said he was surprised to hear this from bankers when meeting with several in late July.

“We meet with bankers all the time and had two meetings this week. For the first time ever I heard bankers tell us to ‘stand pat, [your company] is in good shape,’” he said, adding that his firm has debt maturing early next year, and the bankers typically would have promoted issuing sooner rather than later.

Most corporates have already refinanced into debt at record-low rates and simply don’t need more cash, especially when global economic growth remains sluggish. As growth slows, it becomes ever more challenging for companies to find profitable investments, leading to cash on their balance sheets increasing. Nevertheless, their capital structures remain strong.

“We think companies will continue to do what they’re doing, and except for the occurrence of some major event, we don’t see most companies having to change their capital structures in the foreseeable future,” said Gaurav Sharma, a senior manager at Deloitte Advisory’s treasury practice.

There are certainly worse situations than having a solid capital structure in place and wondering what to do with excess cash. For many companies the goal now is to hold on to their current good fortune as long as possible. To that end, rate swaps on future issuances have come into vogue, enabling corporates to issue bonds in the future while locking in today’s exceptionally low rates.

“The rate on the 10-year is fantastic, but my company doesn’t need the money, so it’s stupid for me to issue more bonds—what would I do with the cash, especially when in many instances there’s a negative carry?” the treasury executive said. “It used to be you’d go out as far as 24 months, then some company went out three years, and this week I heard someone went out five years.”

Amol Dhargalkar, managing director of Chatham Financial’s Global Corporate Sector, said rate swap hedges out as far as five years have happened, but they tend to be outliers. More are in the two-year forward starting range, and the bulk of swaps are less than a year forward starting.

“We’ve definitely seen an overall increase over the last year, and particularly of last six, maybe even three months,” Mr. Dhargalkar said.

No comprehensive data on the increase of rate locks was available, but a general consensus among sources was that corporates have increased their use of the hedges over the last year by about 40%. Why the increase? The Federal Reserve has been expected to raise rates for several years now, and currently heightened expectations, given Fed officials’ hints of at least one hike this year, may be one factor. The historically low level of absolute interest rates are another, said Greg Hart, managing director and head of rates origination for North America at Bank of America Merrill Lynch, who noted that corporates have used rate locks for some time, but recently their use has increased and many now carry longer tenors.

“Now we’re looking at transactions in 2018 and 2019, and in some cases four years out,” Mr. Hart said, adding that five-year transactions have been done in the past but not recently.

Mr. Hart said rate-lock users are Fortune 500 companies, often in the Fortune 100 echelon, and the ones going out three or four years tend to be those that have already benefited most from low rates. They typically have larger capital structures that benefit from lower funding costs, and they’re proactive in managing risk.

“We typically see only those companies with a history of using derivative products going into these longer hedge structures,” he said, noting those hedges are more common in healthcare and consumer/retail, where M&A and share buyback activity has resulted in larger debt issuances.

Another reason for the increase, said Chatham’s Mr. Dhargalkar, may simply be a wave of debt maturing over the next year, so companies want to be sure they lock in today’s rates. In addition, he said, the cost of hedging has come down as the yield curve has flattened. “Companies that looked at rate swaps before might have decided it was too expensive, and now they’re saying that the cost has come down so they might as well,” Mr. Dhargalkar added.

Treasury locks, or T-locks, provide a more precise hedge because, unlike forward starting swaps, another common derivative companies use to hedge future debt issuance; there’s no basis risk. However, T-locks require using the hedge on a specific date in the future, while forward starting swaps provide more flexibility. Hence the latter tend to be more appropriate for hedging going out past a year, Mr. Dhargalkar said, adding that forward starting swaps are transparent and typically liquid instruments. “A company has to dig in and figure out how well its bonds are priced over Treasurys compared to swaps, and how much risk that savings might create,” he said, adding, “The longer out you go, the more efficiency you get using forward starting swaps vs. T-locks.”

Mr. Dhargalkar said achieving hedge accounting for T-locks can be a complicated affair, while the accounting for forward starting swaps tends to be easier, a factor driving more companies toward the latter.

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