Inflation Has Firms Using Derivatives to Lock In Funding Costs

(Bloomberg) — US companies are turning to derivatives to lock in future borrowing costs, as corporate finance chiefs worry that financing will grow more expensive amid stubborn inflation, even if markets are bracing for rate cuts in 2023.

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The Fed has hiked short-term rates over the past year at the fastest pace in decades, and is widely expect to boost them again by a quarter-point on Wednesday. What happens after that is unclear: markets are betting that the central bank will pause, and start trimming rates later this year. But many company executives don’t foresee monetary easing by the end of December.

Rate markets reflect some of that uncertainty: The ICE BofA MOVE index, which tracks fluctuations in options on a series of Treasuries, spiked in March as a handful of banks started collapsing, and at 128.18 on Monday was well above its 10-year average of about 72. Banks usually don’t disclose volumes for hedge derivatives, but say they’re seeing more demand from corporates for instruments that help companies lock in borrowing yields.

“After the financial sector stress in March, rate locks became even more popular,” said Steve Martorana, head of US corporate rates risk management solutions at Deutsche Bank AG. “The motivation is for companies to get certainty around future financing costs.”

Keeping a lid on borrowing costs is crucial after the Fed lifted interest rates to a range of 4.75% to 5.00% since March 2022. Corporations have ample need to borrow in the coming months: investment-grade rated US companies have an estimated $427 billion maturing in the second, third and fourth quarters of 2023, according to S&P Global Ratings. Next year, $720 billion in US investment-grade debt is set to come due, S&P said.

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The companies putting these trades in place are often highly rated. The transactions they execute, also called pre-issuance hedges, can come in a few forms. One entails a T-lock, which is a synthetic agreement that allows issuers to essentially lock in the Treasury yield.

Corporations may also use derivatives such as forward-starting swaps, or options on swaps known as swaptions, to get more certainty around future funding costs. In some cases, they’re hedging issuance that’s not expected to happen for several months or even years.

“The goal is to have a better rate to issue at than the market rate,” said Joseph Neu, founder and chief executive of NeuGroup Inc., which runs membership groups for treasurers.

Some companies still benefit from the hedges they took out in 2020 and 2021, when rates were low. “At rates of 1%, you can only be so wrong,” said Amol Dhargalkar, chairman and managing partner at Chatham Financial Corp., a financial services firm.

Issuance Insurance

Cintas Corp., a Cincinnati-based company that offers work uniform rentals and other business services, plans to use a $500 million hedge for a 2027 maturity, when it has $1 billion in 3.70% debt coming due.

“We did this back in 2020 and we felt that, gosh, the rates were so low, let’s lock it in,” said Mike Hansen, the company’s chief financial officer.

Cintas views its T-locks as insurance, Hansen said. The company has locked in a Treasury rate of less than 2%, but will have to add the costs for the credit spread when it sells debt to refinance, he said.

“If we have certainty that we will issue debt or refinance debt, and we are comfortable with a rate opportunity, a T-lock can remove some risk surrounding that future issuance,” he said. Cintas in 2022 was able to refinance debt at roughly the same effective interest rate despite increases in the Fed’s benchmark rate, Hansen said.

Some companies use pre-issuance hedges opportunistically. Prologis Inc., a San Francisco-based warehouse landlord, estimates it has saved about $100 million with its rate hedging program over the past three years, according to CFO Tim Arndt. The company doesn’t have significant bond maturities until 2025, but it takes out pre-issuance hedges when it sees good opportunities to do so. The company has been a frequent user of T-locks and swaptions in the past five years, Arndt said.

“With the Treasury market so volatile, we can just spot the dips and put some hedges in,” Arndt said.

There can be temporary effects on Treasuries — for example when a bulk of issuers comes to market, as seen on Monday, when companies including Meta Platforms Inc. priced $22 billion in new debt, and investor sentiment improved after JPMorgan Chase & Co. announced it would acquire First Republic Bank. Still, pre-issuance hedges don’t usually have significant impacts on the Treasury markets, according to Chatham’s Dhargalkar.

Whether companies will continue to enter into new pre-issuance hedges will depend on market expectations for rates longer term, bankers and advisers said. “A lot of our clients don’t believe the extreme rate cuts that are being priced into the Treasury curve,” said Deutsche Bank’s Martorana. “To them, it still makes sense to lock in benchmark rates.”

Near-term rates that are generally above longer-term rates and stubbornly high inflation are spurring some corporations to hedge now. “The inverted yield curve is creating an economic incentive for companies to lock in longer-term rates,” said Shiv Vasisht, co-head of global rates and currencies solutions at Bank of America Corp.

“What’s catching attention is this unique market environment,” said Amy Yan, co-head of global rates and currencies solutions at Bank of America.

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