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Minneapolis, MN | August 9, 2022 | Scott Talcott, Senior Vice President
Out of control inflation, war, geopolitical tensions, and China’s recent mortgage defaults and boycott are some of the issues that have led to market volatility this year. In a response to inflation running at its highest levels since the early 1980s, the Fed has delivered some of the biggest interest rate hikes in decades, with 75 bp increases in both June and July. Since the beginning of this year, the fed funds rate has sharply risen from close to zero to a target range of 2.25% to 2.50%. While this has put a strain on variable rate borrowings, it has also led to market opportunities via yield curve relationships. The “normal” shape of the yield curve has historically been positively/upward sloping (with short-term rates lower than long-term rates); however, the magnitude of this slope has been shrinking with every Fed rate hike and has been consistently negative since early June.
A common market indicator to gauge the shape of the yield curve is the “spread,” or differential, between the ten-year and two-year U.S. Treasury Notes. On August 8, 2022, the spread reached a level of negative 45.4 basis points (-0.454%), which exceeds even the spreads prior to the Great Recession. For context, this degree of inversion between the 2Y and 10Y treasuries has not been seen since the late 1980s and early 2000s. We may see this spread become more negative if further Fed rate hikes continue to outpace increases in long-term rates. The graph below shows a long-term history of the differential between the ten-year and two-year U.S. Treasury Notes.
As a result of the inverted yield curve, currently there are a few key points that borrowers and market participants should consider. The cost of capital for utilizing a long-term financing structure versus a shorter-term financing provides an economic advantage relative to the historical norm. Also, today’s high short-term rates provide attractive opportunities for reinvestment of bond proceeds, minimizing the negative carry of escrows and project funds. Another silver lining of the inverted yield curve is that the economic cost of executing a forward-settling financing has decreased, making these types of financings relatively more attractive than in the past. Similar to forward financings, forward-starting interest rate swaps can be executed to lock in capital costs as well. Furthermore, a forward-starting interest rate swap may be less costly than a spot-starting one depending on the term of the forward start. In other words, executing a swap that starts today may be more expensive than executing a swap that starts in the future. That being said, although these reduced costs may appear attractive, borrowers should prudently evaluate all economic and non-economic risks associated with these instruments before making a final decision.
Lastly, depending on the evolution of the SOFR interest rate swap market, borrowers may find themselves being approached by counterparties regarding the execution of a constant maturity swap (CMS), or may themselves be interested in such a product. Similar to a plain vanilla, fixed-to-floating interest rate swap (where one party pays a fixed rate and the other party pays a short-term variable rate), a CMS pays a longer-term variable rate such as the 5- or 10-year swap rate. A CMS can also involve payments based on two variable rates, one short-term and one long-term (also known as a basis swap). Given the inversion of the swap curve, the cost differential between a swap paying a short-term variable rate versus a longer-term variable rate has decreased relative to historical levels and may be attractive to issuers. Using a CMS issued under current market conditions, a borrower with debt based on a short-term index may effectively hedge its short-term variable interest rate risk with a longer-term variable interest rate. In theory, the borrower may benefit from receiving the longer-term rate if the yield curve reverts to the historical norm.
Volatile markets bring difficulties, risks, and opportunities, all of which are increased with the magnitude of said volatility. We encourage you to reach out to a Blue Rose advisor to assist in evaluating these concepts and determining whether they may be beneficial for your institution to consider.
Comparable Issues Commentary
Shown below are the results of two private tax-exempt higher education issues that priced in the month of June. Lake Forest College (“Lake Forest”) priced its tax-exempt Series 2022A on June 23rd. On the previous day, Chatham University (“Chatham”) priced its tax-exempt Series of 2022. Lake Forest’s bonds were issued as a combined refunding and new money issuance. The refunding component of the deal served to refund the College’s outstanding Series 2012 bonds along with its Series 2014 direct purchase. Lake Forest also elected to terminate an interest rate swap related to the 2014 Bonds, for which it received a small termination payment from the counterparty. The new money component of the deal was issued to improve and modernize various facilities around the College’s campus and was sized in conjunction with the refunding purposes to meet aggregate debt service targets established by the College. Chatham’s issuance was purely for refunding purposes, with the entirety of the University’s bonds serving to current refund its Series 2012A Bonds.
Both schools’ bonds were rated lower in the investment grade category, with an identical rating of “BBB-” from S&P. Lake Forest’s transaction had a longer amortization structure than that of Chatham, stretching a full 30 years along the yield curve and featuring serial maturities in 2023-2032 followed by five term bonds in 2035, 2039, 2042, 2047, and 2052. In contrast, Chatham’s issue carried a shorter duration, with serialized maturities through to its 13-year final maturity in 2035. Chatham also issued its bonds with a slightly shorter 9-year call option relative to Lake Forest, which utilized a standard 10-year call. Both transactions used a blend of primarily 5% and 5.25% coupons, with Lake Forest also using 5.5% coupons for some of its longer-dated term bonds. Additionally, the two deals differed modestly in size – Lake Forest’s Series 2022A issue totaled $38.15 million, while Chatham’s Series of 2022 was smaller at $22.29 million in total par amount.
Lake Forest and Chatham were each able to take advantage of a rebound in the tax-exempt market after several months of turbulent market conditions, increasing interest rates, and credit spread volatility preceding their bond pricings in late June. Both deals priced the week following the Fed’s announcement of a 75 bp interest rate hike. Markets were closed Monday for the Juneteenth holiday and MMD remained flat on Tuesday. On Wednesday, the day of Chatham’s pricing, MMD fell 3-4 bps across the yield curve. The following day when Lake Forest priced, MMD fell a further 5-10 bps across the curve. Lake Forest’s Series 2022A achieved spreads of 162-205 bps on its serial maturities before widening out to spreads of 215-227 bps on its term bonds. Chatham’s Series of 2022 had spreads of 160-205 bps on comparable 5% non-callable maturities with spreads of 211-216 bps on its callable 5.25% maturities. Although due to state tax differences Chatham, a Pennsylvania university, might have been expected to price better than Lake Forest, located in Illinois, the two transactions priced at very comparable levels overall, with spreads on most comparable maturities within 5 bps or less of one another.
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Meet the Author:
Scott Talcott | stalcott@blueroseadvisors.com | 952-746-6042
Mr. Talcott provides financial advisory services to the firm’s clients with respect to the planning and execution of all types of debt, derivative, reinvestment, and P3 transactions. He specializes in analyzing and assessing financial strategies from both a quantitative and qualitative standpoint to assist clients in selecting the most efficient use of capital that best aligns with their strategic goals and objectives. He also prepares client-specific financial analyses and has in-depth expertise related to bond and derivative pricing, credit analysis, and debt capacity modeling.
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