By: Brandon Lippold & Craig Haymaker
Rates have fallen and yield curves have flattened (and in some areas inverted) significantly since the start of the year.
By virtue of these lower rates, many borrowers have realized positive impacts to their capital structure in a variety of different ways: embarking on a new financing, a new synthetic fixed rate structure, or simply feeling the effects on an existing “naked” variable rate position. However, many borrowers are also currently experiencing an increase in the negative MTM (mark-to-market) values of their swap portfolios.
A common swap position held by those locking in a synthetic fixed rate structure is that of the fixed rate payer. When variable rates fall, these positions move out of the money as the fixed rate paid drifts higher than the floating rate received. In this structure with rates falling, looking at a swap value in a silo can appear negative; however, when taken in concert with the underlying debt position, this movement should be viewed as part of an overarching hedging strategy. By locking in a synthetic fixed swap rate, a borrower gives up the opportunity to benefit from potential downward movements in its variable rate debt formula but receives a guarantee that their interest expense won’t move above its effective fixed rate (swap rate plus the underlying credit spread) if interest rates rise. The objective behind a perfectly synthetically fixed structure is to lock in a cost of capital, no matter the level of rates. In theory then, as rates have fallen in the past months, the net borrowing rate of existing synthetically fixed structures has remained constant.
A potential externality of this hedge objective is a negative swap value. As the capital markets cope with an inverted yield curve and flattened forward rates, the resulting effect on swap values can be a source of stress for treasury directors and controllers alike. It’s never easy to see increases in liabilities – especially derivative liabilities – and have to explain these changes to senior leaders, finance committees and broader financial statement users. The two key considerations to keep in mind when viewing a negative swap MTM value are related to 1) accounting treatment and 2) potential collateral posting. These two considerations can vary depending on the entity and hedging structure, but below is a crash course on how these two items can be approached.
Entities often use swaps as risk management tools and hedging instruments to mitigate financial risks such as interest rate risk and market risk, or to simply address cash flow variability. While a swap’s purpose may vary, entities have a choice to make when accounting for swap transactions: 1) use a basic derivative accounting approach, or 2) employ hedge accounting.
Under the first option, entities mark-to-market the swap each reporting period to a derivative asset/liability on the balance sheet and record the periodic change in value immediately in the income statement, or statement of changes in net assets. With the second option, entities enjoy a preferential accounting treatment that allows them, for example, to defer derivative losses in an equity or net assets account instead of recording the loss immediately in the income statement or statement of changes in net assets. This accounting treatment, generically known as “hedge accounting,” is addressed by FASB topic 815 and GASB paragraph 53 (depending upon the entity’s legal structure and industry) and effectively reduces the volatility in earnings caused by periodic gains and losses from the swap. This orientation does not suggest that a negative swap value is good or bad; but hedge accounting can lessen the angst felt by financial statement users that may arise from swap liabilities from a financial reporting perspective.
Another potential source of concern in a falling rate environment for entities with swaps comes from posting collateral. Collateral is a mechanism that serves to reduce counterparty credit risk between both parties to the swap. It is exchanged between the entity and the counterparty as follows: if the swap is in an asset position, collateral is posted by the counterparty to the entity via custodian account; and the opposite is true of a liability position whereby the entity posts collateral to the counterparty. Collateral can come in the form of cash or highly liquid instruments such as US treasury securities. Terms for exchanging collateral are governed by a document called a Credit Support Annex, which is an appendix to the International Swap Dealers Association (ISDA) agreement.
Why the concern? Collateral posting can constrain an entity’s liquidity. Bigger entities may possess larger-sized loans with more significant variable rate interest expense. For example, swaps that are executed to hedge those loans will have large notional amounts and thus will require larger collateral amounts to be posted given a substantive decrease in swap value. Also, entities with weaker credit may be required to post collateral at lower thresholds than otherwise better rated institutions. This can trigger a collateral posting at smaller downward swings in the market and/or cause a larger collateral posting that is disproportionate to an entity’s size.
Treasury managers may lament opportunities missed to earn a compelling rate of return on those funds or to deploy them to other meaningful initiatives instead of using them as collateral. However, in spite of some opportunity cost, there is no need to panic because collateral posting is a temporary phenomenon. As the swap nears maturity, the counterparty’s credit risk exposure reduces along with the entity’s obligation to retain collateral within the custodian account. Said a different way, the collateral exchange experienced between the entity and counterparty bank throughout the life of the swap inevitably ends and collateral pledged/received ultimately returns to its rightful owner.
The Shield Conclusion
A swap will always perform in a manner consistent with its design. Rather, it is the market and economic landscapes that will surprise and beguile us. If we can agree on the foregoing points, then why are some entities seemingly challenged by swaps and the way they behave given adverse market conditions?
It all boils down to managing expectations and utilizing basic risk management principles. It is the duty of risk managers, treasurers and controllers to understand how tail events influence swaps and their impact on financial statements. Given the longer-tenor transactions common to the tax-exempt space, swap users should not only consider the effects of rates falling but rising as well. As such, techniques like stress testing and scenario analysis provide crucial insight to consider in advance of executing a swap. For example, shocking interest rates up and down 1%, 2% and even 5% shows how the swap is expected to change in value and its corresponding effect on expected collateral obligations. Showing key stakeholders and senior leaders what could happen to your swap portfolio may make all the difference when interest rates do exactly what we thought they would do…remain unpredictable.
 An ISDA agreement is needed to consummate the derivative transaction between the user and counterparty bank.
About the Author:
Brandon Lippold, Associate
Brandon provides financial modeling, analytics, market data and research in support of the delivery of capital planning, debt and derivatives advisory and reinvestment services to Blue Rose clients. He holds a bachelor’s degree in financial management from the University of St. Thomas and is a Series 50 licensed municipal advisor representative.
Craig Haymaker, Chief Operating Officer
Craig oversees the risk management consulting, hedge accounting and valuation groups at HedgeStar. He is a subject matter expert in financial reporting and accounting for debt, equities, derivatives and other financial instruments. Craig holds a Bachelor of Business Administration degree in Accounting from Stonehill College, and earned his CPA accreditation in 2010.
Comparable Issues Commentary
Shown below are the results of two negotiated, taxable higher education century bonds that sold in the month of September. The University of Virginia (“Virginia” or “UVA”) and Rutgers, the State University of New Jersey (“Rutgers”), priced their bond issues on September 5th and September 10th, respectively. Both deals were sized similarly, with Virginia borrowing $350 million and Rutgers borrowing $330 million. Virginia’s deal carried “AAA” ratings from all 3 major rating agencies, while Rutgers’ bond issue carried ratings of “Aa3” from Moody’s and “A+” from S&P.
The two transactions each were primarily intended to finance future capital improvements on the Universities’ campuses, with Virginia also utilizing the issue to refinance outstanding commercial paper obligations and to reimburse itself for previously expended capital project costs. Both deals were structured with 100-year bullet maturities, using the “century bond” structure that has garnered renewed interest from higher education institutions due to the dramatic decline in long-term borrowing rates in 2019. Both UVA and Rutgers were able to lock in sub-4% borrowing rates – along with the University of Pennsylvania (“UPenn”), which issued its own century bond in August, these 3 transactions are the first of their kind in U.S. higher education to achieve 100-year borrowing costs below that 4% threshold. On a spread basis, Virginia’s century bond priced 117 bps above the 30-year treasury (comparable to UPenn’s 115 bp spread in early August and 20 bps tighter than UVA’s prior 2017 century bond issue), while lower-rated Rutgers priced 172 bps above the 30-year treasury the following week.
Interest Rate Charts