On Sunday afternoon the Federal Open Market Committee (FOMC) reduced its target rate by 100bps to a range of 0-0.25%. Zero per cent interest rates are quickly becoming a reality in the United States. In fact, treasury inflation-protected securities or TIPS actually went -0.01% in the market this week - the first interest rate security with a negative yield in U.S history. With interest rates so low, questions have arrived regarding our corporate and credit union clients’ debt and special hedge accounting relationships.
What Do Zero Percent Floors Mean For Borrowers
As interest rates continue to fall under deflationary pressure due to lack of economic activity, it appears that negative yields may not be off the table in the U.S. after all. Many of our interest rate clients have issued debt that contains a zero per cent floor. It was just a few months ago that we thought interest rates were on the rise so the floors have not been top of mind until now. Clients with a zero per cent floor will not be able to participate in the benefit of negative rate based borrowings. Zero isn’t a bad place to borrow obviously but it is a good idea to understand fully what the lower bounds are in your current credit facility agreement.
Hedge Accounting Impacts
Some of our clients have hedged their debt with a swap that mirrors perfectly or near-perfectly the zero per cent floor via a swap containing a similar floor. These clients often use a qualitative effectiveness test to support a highly effective hedge relationship for hedge accounting. These clients can continue to affirm effectiveness with qualitative testing approaches even if yields in the market fall below zero. But as interest rates continue to fall those clients that hedged their zero per cent floored debt with swaps that ignored the floor may need to rethink compliance with the ASC 815 special hedge accounting rule set. These swaps have dramatically changed in value, but not as much as the floored debt, and what was once a near-perfect offset may no longer be the case. ASC 815 states that companies that utilize a qualitative effectiveness test approach must assert quarterly that the facts and circumstances that led to this approach remain intact. As interest rates approach zero we believe that our clients should revert back to a quantitative test to ensure a highly effective relationship still exists. Relevant guidance is located below:
Accounting Guidance ASC 815-20-35-2D
If an entity elects to assess hedge effectiveness on a qualitative basis and then facts and circumstances change such that the entity no longer can assert qualitatively that the hedging relationship was and continues to be highly effective in achieving offsetting changes in fair values or cash flows, the entity shall assess the effectiveness of that hedging relationship on a quantitative basis in subsequent periods. In addition, an entity may perform a quantitative assessment of hedge effectiveness in any reporting period to validate whether qualitative assessments of hedge effectiveness remain appropriate. In both cases, the entity shall apply the quantitative method that it identified in its initial hedge documentation in accordance with paragraph 815-20-25-3(b)(2)(iv)(03).
Current Market Conditions & Dislocations
Current market conditions are stressed, to say the least. The remote work environment where traders and credit research analysts are located in different locations has put stress on the system. More significantly, there is much greater volatility with liquidity for some products in short supply, making market makers and lenders are extra cautious. All of this leads to wider spreads and pricing delays for both the hedging and financing sides. Zero per cent floor valuations have been particularly impacted by the recent fall in rates pushing prices up precipitously on these instruments.
At Hedge Trackers, we assist our clients in navigating this potential minefield. Our analytics and consulting teams are able to provide information around when might be the best time to hedge your debt. They can discuss with you when it is valuable and worth including a zero per cent floor in your swap vs. leaving it out. We can run scenario analyses for our clients on a variety of structures including a full swap tenor paired with a short-dated floor for near term protection. The right answer today may change tomorrow as the market settles into the new normal. We can help your company evaluate hedge strategies tailored to meet your immediate needs.
A Changing Market
We are now seeing lenders requesting floors on debt that are higher than in the past. Zero per cent floors have been commonplace but now that we’re at zero rates, lenders are seeking floors of 0.5-0.75% strikes. In general, execution spreads have widened and we expect credit spreads to trend upwards as well making it important to understand the correlations between different risks. Only through research, indicative pricing, and review of a variety of possible hedge strategies can the best-suited hedge strategy be crafted for our clients.
All that said the Fed and the government is encouraging lenders to lend. They have reduced the reserve requirements to zero and are no longer paying interest to lenders on reserves held at the Fed. Recently it’s been made clear that the Fed will back loans made to the public by lenders to get the system working again. With rates so low locking in debt now may make a lot of sense but it will take some work to figure out the most cost-effective and best-suited structure for each company.
The FOMC has reduced its interest rate target range to 0-.25%. This is an opportunity to issue debt at an all-time low. Hedgers who’ve previously hedged their debt should review their derivatives and credit facilities for details about any floors that may be contained therein. If there is a mismatch in floors between the debt and the derivative (if the debt has one and the swap doesn’t) you will be required to revisit your hedge accounting effectiveness assessment methodology. As market conditions change the change in the value of a zero per cent floor may provide enough ineffectiveness to the relationship to threaten hedge accounting. Although there are some market dislocations, there is still a great opportunity to issue and hedge variable rate debt. It makes sense to evaluate the timing and a variety of instrument types and strategies before executing your hedge strategy. (For assistance on managing an existing or new hedge relationship contact us at hedgetrackers.com)
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