Companies are using price differences in the debt and derivatives markets to lower the amount they have to pay to borrow money. Investors who want to take advantage of rising interest rates buy the debt, even if the extra yield will only last for a year.
This year, a lot of investment-grade companies in the US sold bonds that allow the issuers to buy back their securities if interest rates drop enough to make refinancing worthwhile. This is a feature that isn’t usually found in high-grade notes. The debt usually comes due in three years, and companies usually have the option to buy back the bonds after 12 months. This is called “calling the securities.”
According to data gathered by Bloomberg News, investment-grade companies sold $8.6 billion worth of “three-year noncall one bonds” (3NC1s) in 2023. That’s about 50% more than all of last year’s sales. AT&T Inc., a telecommunications company, Eli Lilly & Co., a pharmaceuticals company, Amgen Inc., a biotech company, and Stanley Black & Decker Inc., a tool company, are just some of the well-known companies that have recently come out with new products.
According to a report released this week by CreditSights Inc., a research firm, companies that sell 3NC1s can cut their borrowing costs by a large amount by hedging with derivatives at the same time they sell bonds.
As part of this deal, the company needs to do a trade with a bank called an interest-rate swap. This turns the bond the company issued into a floating-rate obligation, which is like a loan, CreditSights strategists led by Winnie Cisar wrote. The swap must have a certain feature: the bank must be able to cancel it at any time after a year, just like the company can buy back its bonds after a year.
Cisar said in an interview on Friday-
“There’s a strong likelihood that investment bankers and debt capital markets teams are out pitching these transactions with the swap”
The deal can also make sense for the issuer because it can be a cheaper way to get money than a term loan. The callable bond can be paid off early, just like a loan.
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Less expensive money
In a hypothetical case that CreditSights looked at, a company that sold a 3NC1 with a 4.9% coupon could cut its annual interest costs by 0.6 percentage points by doing a swap instead of just issuing a standard three-year fixed-rate bond that can’t be bought back. In the end, it would borrow money for less than the Secured Overnight Financing Rate, which is an unusually low price for a company.
The funding benefit comes from the fact that bond markets put a different value on a company’s right to call its debt than they do on the bank’s right to cancel the swap. Both are basically interest-rate options, but the derivatives market is more expensive than the bond market for that option. In this deal, when the company issues debt, it is buying the option from money managers. When it enters a cancelable swap, it is selling the option to Wall Street firms.
Flipped Curve
Another thing about markets right now is that short-term rates are higher than long-term rates. This is called an inverted yield curve. Investors are clamoring for short-term bonds with higher yields, and many are happy to sell options to companies in exchange for even higher interest payments. Money managers are usually happy to own bonds from high-quality issuers they already know. Even if the securities are redeemed after a year, they will have earned a fairly high amount of interest.
“Because of the extreme inversion of the yield curve, the value of the cancelable swap is much higher than the premium that bond investors charge for the call option,” said Maureen O’Connor, global head of high-grade syndicate at Wells Fargo & Co.
CreditSights says that it’s hard to know for sure if companies are choosing swaps because they often don’t reveal these derivatives until their next quarterly filing. The research firm said that of all the companies that sold 3NC1 securities last year, only General Mills Inc. said it had done an interest-rate swap. Amgen, AT&T, Eli Lilly, and Stanley Black & Decker all said they didn’t want to say anything.
And both CreditSights and bankers who have looked at these deals say that there are risks for companies that use this arbitrage. For example, if the economy went through a hard recession, interest rates could go down while the risk premiums, or spreads, on corporate bonds would go up a lot.
The company’s bank would probably cancel the swap at that point. But with wider spreads on its debt, it might not be able to save money by refinancing its debt, leaving it with a fixed-rate obligation. CreditSights said that in this case, it might have been better to issue bonds that couldn’t be called back, maybe with a longer term.
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