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Posts Tagged ‘Interest Rate Swaps’
Monday, February 1st, 2010 by Ron Carleton
In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond. For one company, Jarden Corporation, we showed that the bond’s cost is 50 basis points higher than the loan’s cost. Since both debt instruments were issued by the same borrower, shouldn’t they cost the same?
Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two. This applies if you are looking at it from the perspective of the issuer or the investor. For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).
 Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. “high yield”) bonds is typically higher than the yield on non-investment grade (i.e. “leveraged”) loans. This is because high yield bonds are more risky to own than leveraged loans, for these reasons:
- Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured. Thus, in a bankruptcy, the loans should get repaid before the bonds.
- Maturity and Amortization: Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years. In addition, bonds typically have “bullet” maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time. This longer maturity and lack of amortization make bonds more risky to own than loans.
- Covenants: Loans have more (and more restrictive) covenants than bonds. Thus, as a company’s operating performance begins to deteriorate, the loan will default long before the bond. This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.
Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.
Issuer: Risk vs. Cost
As with Jarden, for non-investment grade issuers, bonds typically have a higher all-in-cost than loans. This is because bonds are less risky for issuers and provide issuers additional flexibility.
- Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it. If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk. Companies can reduce their refinancing risk by issuing debt with longer maturities. The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
- Flexibility: Bonds place few restrictions on a borrower’s operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.
Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.
Loan-Bond Relative Value
When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis. In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.
- If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.
- If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.
Tags: CAPS, Covenants, debt structure, Financial Strategy, Flexibility, Interest Rate Swaps, Jarden, Priority, relative value, term loan b
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Tuesday, January 26th, 2010 by Ron Carleton
Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam. On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012. Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities. Over the next 7 months, it completed two transactions.
August 2009: “Amend and Extend”
- In August 2009, the company extended the maturity of $600 million of Term B loans (”TLBs”) from January 2012 to January 2015 through the creation of a “Term B4″ tranche. This new tranche was priced at LIBOR + 3.25%. The remaining $724 million of term loans remain due through 2012.
- Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.
January 2010: Senior Subordinated Notes
- In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020. The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
- The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
- The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.
So which is cheaper?
With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond’s effective cost is 7.625%. So the loan is a cheaper source of capital than the bond? Not so fast! The loan is floating rate – if LIBOR goes up, the company’s interest cost will go up with it. The bond is fixed rate – no matter what happens to interest rates, the coupon on the bond will not change. So we cannot just compare the current loan cost of 3.5% to the bond’s cost of 7.625% – that would be comparing apples to oranges.
Combining a Loan and a Swap
In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate. This is done using an interest rate swap. Let’s swap the loan to a fixed rate, as follows:
Step 1: The company borrows at LIBOR + 325 basis points.
Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.
The current quote for such an interest rate swap is about T+10:
- The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
- The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract.
These transactions can be expressed as follows:
We can now calculate the effective fixed rate cost of the loan-swap combination:
- Payment to loan holders: LIBOR+325 basis points
- Received from the swap bank: LIBOR
- Payment to swap bank: Treasury +10 basis points
The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders. The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335. The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.
Why is the bond more expensive? And why would the company issue the bond if it is more expensive than the loan? Watch the blog for answers to these questions.
Tags: Amend and Extend, CAPS, Covenants, debt structure, Financial Strategy, Interest Rate Swaps, Jarden, term loan b
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