More companies have been using derivatives to lock in borrowing costs on future debt issuance, bankers and consultants say, as corporate treasuries have sharpened their focus on interest rate risk following last year’s steep rise in market volatility.
Energy company NextEra Energy and real estate investment trust Healthpeak Properties are among the companies to enter forward-starting swap contracts in the latter half of 2022, regulatory filings show, in a bid to lower the interest rate sensitivity of their funding plans in the months and years ahead.
This rise in pre-hedging activity has come amid the most turbulent period for bond markets in decades as the US Federal Reserve has moved aggressively to tamp down inflation, once again putting interest rate risk near the top of the agenda for finance departments.
“The reality of the Fed’s desire to fight inflation is really starting to sink in. The rate risks that companies have in their debt capital structures have become a big topic,” said Amol Dhargalkar, global head of corporates at consultancy Chatham Financial. “More corporate treasurers are realising they need to be doing pre-issuance hedging."
The Fed raised interest rates last year at the fastest pace since the early 1980s, sending bond yields spiralling higher. The yield on the 10-year US Treasury peaked at 4.25% in October, its highest level since mid-2008, having started the year around 1.5%. That sharp increase and accompanying volatility disrupted the debt funding plans of many companies and led to the worst year for US high-grade corporate debt issuance since 2013, IFR data show.
It also highlighted the potential benefit of pre-hedging, when highly rated companies that price their bond issuance off Treasury yields in the US or interest rate swaps in the eurozone look to fix the interest rate proportion of future debt financings.
Damping volatility
A typical example could involve a company that plans to issue a five-year bond in six months’ time to refinance some debt coming due at that point. To do this, it could enter a forward-starting derivatives contract that will lock in its interest rate level immediately, providing some insulation from potential market swings around the time of the planned debt issuance.
In previous years, when central banks had pinned interest rates near to zero, companies tended to look at pre-hedges as a way of locking in ultra-low borrowing costs ahead of time. That's no longer the case following last year's rise in interest rates, consultants say, with many companies instead focused on how to insulate themselves against any pick-up in volatility around the time they're planning to tap bond markets.
"Public companies only have a few windows to issue debt. What if they’re not good windows?" said Dhargalkar. "What if there are extreme levels of volatility and you’re stuck having to price a bond in far from ideal market conditions? That’s where pre-issuance hedging can de-link underlying market pricing from your issuance timing decision.”
Interest rate volatility surged in 2022 as central banks struggled to get a handle on inflation, and that had a clear impact on companies' funding plans. US high-grade corporate debt issuance fell 34% to US$94bn in the second quarter from the previous year following Russia's invasion of Ukraine, a sharp rise in energy prices and rise in bond yields.
Many companies decided to take advantage of a calmer market backdrop later in the year to put on pre-hedges, bankers say. The 10-year Treasury yield dipped as low as 3.40% in December from its October peak, before climbing back to about 3.70% in early January.
“The rally in US rates in the last two months of the year provided a good opportunity for clients to lock in interest rates on future bond issuances that they may be planning to do in 2023," said Flavio Figueiredo, global head rates and currencies, corporate sales and solutions at Citigroup.
"It’s been attractive for clients to put on rate locks, or forward swaps, locking in the interest rate level of issuance that they may be doing in 2023 and we’ve seen quite a lot of that activity. Companies with acquisition financing in particular have been quite actively pre-hedging," he added.
Locking in
Companies opting to fix at levels of interest rates that many would have considered exorbitant only a year earlier underlines the material shift in market expectations over that time.
NextEra Energy in October entered a US$10bn notional forward-starting interest rate swap agreement to "manage interest rate risk associated with forecasted debt issuances", it said in regulatory filings. Healthpeak in August entered two forward-starting interest rate swaps to hedge US$500m of senior unsecured delayed-draw term loans.
Meanwhile Americold Realty Trust, another REIT, said in December it entered a forward-starting swap hedging US$200m of an unsecured term loan. That hedge is due to come into force near the end of this year, replacing another swap that is set to mature at that time.
Elsewhere, companies that decided to pre-hedge when rates were far lower in previous years have found themselves sitting on sizeable gains following 2022’s upwards lurch in bond yields. Rail freight specialist CSX Corp entered forward-starting swaps with US$500m notional in 2020 to pre-hedge the expected refinancing of US$850m in debt maturing in 2027. At the end of September, the fair value of the swaps was US$173m, up from US$91m at the end of last year, filings show.