Chief financial officers (CFOs) and treasurers are constantly evaluating their companies' capital, looking for opportunities to create optimal financing structures and reduce interest expense. Most sophisticated companies tend to utilize a combination of capital markets and derivatives to craft the best solutions, and multinationals, in particular, face great opportunities and challenges. The multiple mini-cycles that credit markets have experienced over the past several years created two multifaceted issues for multinational companies: hedging the risk associated with floored term loan debt and financing in suboptimal currencies.
Hedging Floored Term Loan Debt
In the historically low rate environment of the last several years investors clamored for yield protection, leading many multinational companies to issue floating rate term loan debt with embedded floors based on the London Interbank Offered Rate (LIBOR).
With a floor on LIBOR, borrowers are unable to benefit from historically low rates today, in exchange for continued access to capital. LIBOR floors have become increasingly common within the higher yield (lower rated) part of the credit spectrum, ranging from as low as 0.75 percent to as high as 1.50 percent on LIBOR.
Some view this as being "hedged," reasoning that a LIBOR floor of 1 percent would imply that the cost of debt would not increase until LIBOR exceeds this level. But this view ignores the fact that the cost of debt increases when LIBOR exceeds the floor, resulting in one of the least effective "hedges" as it stops working when it is most needed, during rising rates.
The more effective solution involves the use of interest rate swaps, where the objective is to lock in interest expense regardless of the level of the underlying floating rate (e.g., LIBOR). In a typical vanilla swap, a borrower receives payments on LIBOR in exchange for payments on a fixed rate, where the LIBOR inflows on the swap from the swap bank to the borrower offset the LIBOR outflows on the debt from the borrower to its lending banks.
When a borrower it hedges floored debt with a vanilla swap, it introduces a new type of variability. Perhaps counter intuitively, as LIBOR decreases, the cost of debt actually increases because the swap is not compensating the company for the floor embedded into the financing.
For example, imagine a company borrows at a variable rate with a 1 percent LIBOR floor. Then imagine this company enters into an interest rate swap at a fixed rate of 0.75 percent. If LIBOR resets at 0.3 percent, the company must pay 1 percent to the lender but only receives 0.3 percent back from the swap counterparty. This represents a net loss of 70 basis points, in addition to the fixed rate that the company is paying on the swap (0.75 percent in this example) for a total interest expense of 1.45 percent.
The company's exposure is...