Analysis: Companies' derivative bets to save on US debt costs turn riskier

Plains All American Pipeline LP

27/06/2023 12:00

(Repeats story that ran earlier in the day, with no change to
text)

        * 
      Demand slows for debt-cost saving hedges as economic
uncertainty
mounts
    

        * 
      Bankers say the risk of losses are high on such trades if
done
now
    

        * 
      Lowe's, Merck among those for whom recent trades have been
profitable 
    

        * 
      
    

  
    By Shankar Ramakrishnan
       NEW YORK, June 27 (Reuters) - A type of derivative trade
that became popular with companies over the past year to save on
interest costs is seeing demand slow, with risk increasing that
the bets could backfire as the Federal Reserve nears the end of
its policy tightening cycle.
    The so-called pre-issuance hedges are derivative trades in
bond markets that seek to make money from a bet that interest
rates will rise, allowing the company to then apply the profit
to offset the cost of debt issuance in the future. In essence,
they lock the interest rate on a future bond sale.
    Such hedges are particularly useful for companies that
expect to issue debt a few months out but anticipate interest
rates will rise. Companies such as home improvement store Lowe's
 LOW.N  and drugmaker Merck  MRK.N  have made millions of
dollars through these hedges in recent months, securities
filings show.
    The success of these hedges, however, depends on timing. If
interest rates unexpectedly fall, the trade could saddle the
company with large losses instead.
    With the Fed approaching the peak of its rate hiking cycle
and the market deviating from the central bank's guidance on how
long rates will be kept high amid economic uncertainty, it is
getting harder to predict the future course of rates. The risk
the trade will lead to a loss instead is increasing, several
bankers said.
    "The risk of falling Treasury yields seems more plausible
than rates moving significantly higher," said Richard Wolff,
head of U.S. syndicate for Societe Generale. 
    "So some CFOs may be reluctant to use derivative strategies
to lock in rates here because if things move against them, they
may not want to go to their boards and say they were taking a $5
million hit on a bad derivative bet," he said.
    Scott Shulte, a senior debt capital markets banker at
Citigroup, said the demand for such trades at current yields was
diminishing. Those that were still considering the trades were
taking on shorter-term hedges, such as intra-day or intra-week
bets, rather than longer-term bets like they did last year due
to the mixed perception on the direction of U.S. rates, he
added.
    
        
    IN VOGUE
    The developments show how it is getting harder for companies
to navigate the rate and economic environment. 
    Derivatives were seldom taken up by companies in an era of
near-zero interest rates before 2022, as they exposed them to
risks that were not strictly business-related. They came into
vogue as the Fed embarked on its fastest rate increase cycle
since the 1980s.
    
    Reuters could not determine the overall value of these
trades, which are done bilaterally mostly between companies and
banks. But a review of filings and interviews with the bankers
show they have grown.
    The trades include a complex set of bets - a wager that 10-
and 30-year Treasury bond will fall; and swaps, in which fixed
interest rate liabilities are exchanged for floating interest
rates.
    If 10-year Treasury yields rose 50 basis points after a $500
million hedge, for example, a company could save as much as $2.5
 million through these hedges, according to Amol Dhargalkar,
managing partner of Chatham Financial.
    The 10-year Treasury rose 200 basis points since January
2022.
    "With the speed at which rates rose in the past year, not
taking on a hedge would have been a riskier option for
companies," said Dhargalkar. "It comes down to how confident you
are that rates won't move unexpectedly on the issuance date."
    
    PROFITABLE BETS
    Several companies have entered into such hedges. Lowe’s
settled some $2 billion of forward interest rate swap contracts 
in March 2023 and made a $247 million profit, a regulatory
filing showed. 
    It also settled similar contracts for $1.5 billion in March
2022, and made a $143 million profit then. 
    Shiv Vasisht, co-head of global rates and currencies
solutions at BofA Securities, said the biggest demand for such
products was from companies that planned to issue bonds to fund
deals and other strategic activity.
    For example, Kenvue  KVUE.N , which issued $7.75 billion in
bonds to fund its separation from Johnson & Johnson  JNJ.N  in
March, said in a regulatory filing it had entered into swaps in
the fourth quarter of 2022. As of January 1, it said the net
gain on derivatives was $10 million after-tax. 
    Similarly, Merck entered into pre-issuance hedges in March
and April worth $700 million ahead of a $6 billion bond deal to
fund its acquisition of Prometheus that was priced in May. 
    As long as there was uncertainty, companies will be
interested in taking on such hedges, said Amy Yan, co-head of
global rates and currencies solutions at BofA Securities. It is
about "sound risk management," she said.

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U.S. federal funds target rate    https://tmsnrt.rs/43YOqKu
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 (Reporting by Shankar Ramakrishnan in NEW YORK; Editing by
Paritosh Bansal and Muralikumar Anantharaman)