Interest Rate Hedging Best Practices & Pitfalls to Avoid March - - PDF document

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Interest Rate Hedging Best Practices & Pitfalls to Avoid

Ruth Hardie rhardie@hedgetrackers.com

March 14, 2017 @ SVAFP

& INTEREST RATE

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• Risk Mitigation Scenarios focused on
• Fixing variable interest expense
• Locking in the fixed rate of bonds/notes
• Typical Instruments
• Swaps
• Caps
• Pitfalls to Avoid

Agenda

IR Risk Mitigation Scenarios

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Risk Mitigation Scenarios

“Faced with the threat of rising interest rates, plenty of chief financial officers are wrestling with whether to issue fixed- or floating-rate debt. That’s because even small fluctuations in interest rates can cost or save a company millions of dollars in interest expenses. The decision hinges partly on rate expectations. With unexpectedly strong economic growth in the third quarter and falling unemployment, some CFOs predict that the Federal Reserve will detect inflation and raise short-term interest rates sooner than it has telegraphed. On the flip side, business investment and inflation remain decidedly weak, so some finance chiefs believe the Fed will stick to its message and won’t raise rates before at least 2015.”

WSJ Jan ‘14

Risk Mitigation Scenarios

• Fixing variable interest expense
• Term loans, revolvers
• Lock in the fixed rate
• Bonds, notes

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Interest Rate Curves – Less Than 3 Yrs

85 bps

Interest Rate Curves – 4 Yrs & Up

100 bps

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IR Terminology Cheat Sheet

Benchmark Int Rate Cap Cash Flow Hedge Contemporaneous Effectiveness IR Swap MTM Probability Swaption

• LIBOR, Treasuries, OIS
• One party receives int when LIBOR > X% - other party receives a premium
• Protects future cash flows from changes in interest rates
• Hedge accounting documentation requirement (within 2 business days)
• Changes in the hedge offsetting changes in the hedged item
• Two parties exchanging interest - one pays fixed and other pays floating
• Mark to market (i.e. the value at a certain date)
• Probable - > 80%, Possible 20-80%, Remote < 20%
• The option to enter into an IR Swap

Fixing Variable Interest Expense

LIBOR

Fixed

L I B O R

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ASC 815 Basics

• Derivatives must be MTM and the default is to record the
• ffset in the P&L
• Hedge accounting is a privilege
• Cash flow hedge accounting allows you to defer derivative

effective gains/losses

• Ineffectiveness on a cash flow hedge is recorded when the

derivative outperforms the hedged item

Typical Instruments

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Swap Construction

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Vanilla IR Swap Mechanics

3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed interest on $10M A pays B fixed interest on $10M A pays B fixed interest on $10M A pays B fixed interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M

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Net Impact of Swap (@ Trade Date)

The red arrows represent Fixed payments to the counterparty The black arrows represent predicted LIBOR payments to the Company

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Swaps

Pros

• Predictability
• No upfront cash required
• Liquid market
• Customizable

Cons

• Lose the ability to benefit

from low rates

• Locked into a single tenor*
• Locked into a minimum

borrowing

• Loss up to fixed rate

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Success Stories – Construction/Term Loan

0.000% 1.000% 2.000% 3.000% 4.000% 5.000% 3/1/2014 3/1/2015 3/1/2016 3/1/2017 3/1/2018 3/1/2019 3/1/2020 3/1/2021 3/1/2022 3/1/2023 3/1/2024 3/1/2025 3/1/2026 3/1/2027 3/1/2028 3/1/2029 3/1/2030 3/1/2031 3/1/2032 3/1/2033

Actual LIBOR Rates Fixed Rate 3.46% Commercial Ops - 4.46% Profit Lockedin at 1%

Success Stories – Fixed Debt Replacement

0.000% 0.500% 1.000% 1.500% 2.000% 2.500% 3/1/2014 5/1/2014 7/1/2014 9/1/2014 11/1/2014 1/1/2015 3/1/2015 5/1/2015 7/1/2015 9/1/2015 11/1/2015 1/1/2016 3/1/2016 5/1/2016 7/1/2016 9/1/2016 11/1/2016

$1.4M received, $2.4M paid $3.6M savings locked in

$100MM Bond @ 2%

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Success Stories – Rate Lock – 6 months

0.00% 0.50% 1.00% 1.50% 2.00% 2.50% Exit price Lock

Delta - .51% 1.69% 2.20% $920k on $20M over 10 years

Cap Construction

Cap Strike

20

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Vanilla IR Cap Mechanics

12/31/X0 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed Premium A receives 3M LIBOR interest > 1%

• n $10M

A receives 3M LIBOR interest > 1%

• n $10M

A receives 3M LIBOR interest > 1%

• n $10M

A receives 3M LIBOR interest > 1%

• n $10M

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Net Impact of Cap (@ Trade Date)

The red arrows represent premium paid to the counterparty The black arrows represent predicted fair value of each caplet

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Caps

Pros

• Can benefit from low rates
• Predictability above a

threshold

• Customizable
• No credit charges
• Loss limited to premium

paid Cons

• Cash outlay
• Less transparent pricing
• Harder to value
• Locked into a single tenor*
• Locked into a minimum

borrowing

Success Stories – 2% Cap

• 500,000

1,000,000 1,500,000 2,000,000 2,500,000 Premium Savings to date

$400k savings

$100MM hedged for 4.5 years. Currently 17 months into the hedge. Last reset rate was .78%

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Pitfalls to Avoid

Pitfalls – Floating Rate Debt

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Pitfalls – 0% Floors

Cumulative Ineffectiveness $800M amortizing debt hedged over 4-13 years

Pitfalls – Future Fixed Rate Debt

• Blackout Periods
• Hedge window
• Other fixed rate debt
• Swaptions

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Pitfalls – Future Fixed Rate Debt

20000 40000 60000 80000 100000 120000 140000 160000 180000 200000 Swaption Premium Swaption Termination

Intrinsic Value $124,800 Net Premium $47,500 Extrinsic Value $15,200

Thank You

1190 Saratoga Ave, Suite 110 San Jose, CA 95129 Direct: (408) 350-8580 www.hedgetrackers.com

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Ruth Hardie

rhardie@hedgetrackers.com linkedin.com/in/ruth-hardie-0b977b3

Senior Director, Client Services

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