A new CBOT product, the swap note
futures, may help companies manage the spread risk of
expected debt offerings. However, as far as FAS 133
goes, an OTC product will still offer more flexibility
and less chances of a hit to earnings.
On October 26, the Chicago Board of Trade
(CBOT) launched its new 10-year swap futures contract,
a.k.a. "Swap Note” futures. The new contract, structured
a lot like a bond (for more on the contract specifics,
see box)
can help companies manage anticipated bond issues at a
lower cost and far easier structure than using
eurodollar strips.
To be effective as corporate risk
management tools, the swap note contracts will have to
(1) overcome the general corporate inclination to use
OTC products and (2) resolve some of the FAS
133/derivatives accounting issues raised by futures vs.
OTC swaps. More likely, treasurers should rely on the
contracts for invaluable pricing information as they
assess swap prices from OTC counterparts, or else use
them as a prelude to a swap hedge.
Although corporate treasurers typically
shy away from exchange-traded instruments, it is not
inconceivable that treasury use a swap note future as a
prelude to a planned, outright swap position. Currently,
anticipated swaps (ex. in conjunction with a debt
offering) are hedged via forward swap.
Take General Mills, for example: Recent
10Q reports for the company explain how it is exposed to
interest rate volatility with regard to existing
issuances of variable-rate debt and planned future
issuances of fixed rate debt.
To manage these risks, the company uses
interest rate swaps, including forward-starting swaps,
to reduce interest rate volatility, and to achieve a
desired proportion of variable vs. fixed rate debt,
based on current and projected market conditions.
Like other companies, General Mills
accounts for variable to fixed rate swaps as cash flow
hedges. Hedge effectiveness is assessed based on changes
in the present value of interest payments on the
underlying debt. Their company’s 10Qs relate how
unrealized losses of $251.2 million from such cash flow
hedges recorded in OCI were primarily due to
delayed-starting interest rate swaps the company had
entered into in anticipation of a proposed acquisition
of Pillsbury and other financing requirements. This
loss, the report goes on to note, will be reclassified
into interest expense over the life of the interest rate
hedge subsequent to the completion of the
acquisition.
After the market meltdown of
1998—associated with the demise of the ill fated hedge
fund, LTCM—corporate borrowers like General Mills began
hedging planned debt issuances with interest rate swaps
rather than with cash Treasury notes or Treasury
futures. This was due to the extreme flight to quality
that occurred at the time, which caused corporate
borrowing spreads—and by extension swap spreads—to
balloon, even while outright interest rates were
plunging. Swap rates, hence, have been used as a proxy
for new-issue spreads (see here).
This hedging strategy raises a few issues.
First, swap spreads are a proxy only. The correlation of
new issue spreads and swap spreads precludes
company-specific or sector-specific spreads. A more
precise hedge may involve products structured off the
Standard & Poor’s spread index. While the CBOT is
exploring this issue, there’s no available tool right
now to offset the spread risk more accurately.
That said, how would the futures hedge
compare with a traditional forward swap, OTC hedge in
terms of its accounting/earnings consequences?
The FAS 133 treatment
That’s where FAS 133 comes into play.
Issue G18 (see here) addresses this very issue with
the assumption of a hypothetical company expecting to
issue $100 million of 10-year fixed rate debt in six
months.
In one case, as with General Mills, a
company hedges the anticipated borrowing with a forward
starting interest rate swap. In the other case, a
company hedges the interest risk with a short position
in 10-year Treasury note futures.
In the first alternative, the company
documents that its is exposed to variability in cash
flows for the future quarterly interest payments on the
debt due to changes in credit risk and interest rate
risk that occur during this six-month period prior to
issuance. In the second, the company states it is
hedging the variability in the cash proceeds
attributable to changes in the benchmark interest rate
to be received from the fixed-rate debt it will issue in
six months. (Note that FAS 138 has amended the
definition of benchmark, to allow companies to choose
between LIBOR and Treasuries, for example, when
assessing the effectiveness of hedges. The swap futures
contract, treasuries-based, could provide a useful hedge
tool for the spread over treasuries of an anticipated
debt deal since both will be measured against the same
benchmark).
Both examples state that after six months,
the company decides to delay the borrowing by an
additional three months, which raises the question about
whether the company should immediately reclassify the
entire net gain or loss related to the derivative
contract from other comprehensive income into
earnings.
Paragraph 33 as amended by FAS 138
stipulates: "The net derivative gain or loss related
to a discontinued cash flow hedge shall continue to be
reported in accumulated other comprehensive income
unless it is probable that the forecasted transaction
will not occur by the end of the originally specified
time period (as documented at the inception of the
hedging relationship) or within an additional two-month
period of time thereafter."
Though better than the Treasury future,
the relevant issue for use of a swap future contract
would be the standardized delivery dates.
Presumably, a company could forecast a
planned debt offering on a date corresponding with the
expiration of the swap futures contract to minimize
basis risk and possible hedge ineffectiveness. But, a
later decision by the company to delay the borrowing
beyond the two-month window described in paragraph 33 of
FAS 133 suggests the gains/losses from the swap future
would have to go immediately into earnings.
The swap, as G18 illustrates, offers
somewhat more flexibility, in that not all the cash
flows being hedged become improbable when the debt
issuance is postponed. This, plus the ability to
terminate and customize a new swap to the postponed
issuance dates, still makes swap hedges likely to gain
better accounting treatment.
But at what price? The accounting
should not prevent treasurers from pricing out the swap
future hedge alternative to help determine the economics
of the swap they are being quoted. They also should try
to determine what it would cost the swap counterparty to
fully hedge its position on the CBOT—and even point out
the difference if they were to hedge with Eurodollar
futures.