Hedging Pre-Issue Pricing Risk for Fixed-Rate Debt

Many companies today are considering the issuance of fixed-rate debt to lock in cost- effective funding and strengthen their capital base. Interest rates, however, don't always cooperate. Fortunately, there are a number of hedging tools available which can reduce the impact of interest rate fluctuations on prospective debt issues or private placements during the structuring and marketing period before pricing.

Changes in Treasury note yields have a great impact on the price of corporate debt. Treasury locks, caps and collars are three Treasury-linked Bank of Montreal pre-issue hedging tools which fixed-rate debt issuers can use to immunize prospective debt from the impact of interest rate increases.

The Challenge
Companies planning to issue fixed-rate debt are exposed to the risk of Treasury rate movements until the new issue is priced. Even the briefest waiting period can significantly increase exposure. To address this challenge, issuers can choose from a variety of off balance sheet risk management techniques to synthetically hedge the yield on the Treasury security on which the debt will be priced.

Hedging Solutions

• Treasury locks enable issuers to secure current market rates for future fixed-rate funding. As the name implies, a Treasury lock is used to "lock-in" the forward rate of a specific or interpolated Treasury security to a specified date in the future. Treasury locks hedge only the underlying Treasury yield.

• Treasury caps enable issuers to protect against adverse moves in Treasury yields during the hedging period, while retaining the benefit from any future rate decreases. This option-based tool carries a premium based on market conditions, volatility, term, and the level of protection required.

• Treasury collars (the combination of buying a Treasury cap and selling a Treasury floor) can be used to hedge current rates within a targeted range. The cap protects against increases in interest rates. The sale of the floor, which eliminates the benefit from a decline in rates below the floor rate, reduces the cost of the hedge. A Treasury collar can be structured at no upfront cost by setting the cap and floor rates such that the premium received for the floor entirely offsets the premium due for the cap.

For Example
Consider a company that decides today to borrow $100mm for 10 years, with the proposed issue to be priced in six weeks. The company does not want to speculate on the direction of interest rates, and seeks to reduce its exposure until the issue is priced.

Until the debt is priced, the company faces exposure to changes in the underlying Treasury rate; and unhedged interest rate exposure can translate into real money. For example, on a $100 million 10-year Treasury with a current yield of 6.56%, the present value of a one basis point change in rates is $72,000!

As you can see in the table below, the cost impact of even a small change in rates can be extremely large - higher if rates go up, lower if rates fall. If in markets of even average volatility, intraday rate movements alone can be as much as 15 basis point up or down, consider how much is at risk over the typical 1 to 3 month pre-issue period.

Executing a Treasury Lock
To put a Treasury lock into place, the hedger selects an appropriate Treasury note or notes, sets the hedge maturity date (matched to the date when the issue is expected to come to market or the private placement is circled), and agrees to a lock rate with BMO Financial Group.

At the expiry date the Treasury lock is settled.

• If interest rates rise during the hedge period, the cost of the company's debt issue will be higher. However, the Treasury yield will be higher than the lock rate, and the cash payment from BMO Financial Group to settle the Treasury lock will help offset higher costs of financing.

• If interest rates fall during the hedge period, the rate on the new financing will be lower, but the Treasury yield will be lower than the lock rate. This triggers a cash payment to Bank of Montreal, which brings the hedged yield up to the company's original target.

From a financial reporting and a federal tax standpoint, current hedge accounting allows the company to recognize the cost or benefit of the hedge over the life of the underlying debt.

How Much Does It Cost?
The cost of a Treasury lock is determined by the cost to finance the underlying Treasury security over the hedge period. For example, using a 10-year Treasury with a current yield of 6.53 percent where the cost of carry in the government repurchase market is 5.25%, the premium on a six week Treasury lock would be approximately 3 basis points. Thus, the company can lock in a fixed yield on the underlying 10-year Treasury at 6.56 percent. At the end of six weeks, the effective net interest cost for the company's issue would be the fixed yield of 6.56 percent plus its underlying debt credit spread no matter what happens to the market yield on treasuries over that time.

Hedging A Large Debt Issue
For large debt issues companies frequently set Treasury locks in increments, minimizing the odds of locking-in at a temporary market high point. Hedging one-third to one-half of the principal amount of a proposed debt issue at a time eliminates interest rate risk on a significant portion of the debt and produces a "dollar cost averaged" lock rate.