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.

Corporate applications

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.

Why swap spreads?

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.