1. Should we lock in today's interest rates?

Investment-grade companies are issuing debt in record amounts in 2020, driven by a desire to buttress liquidity and take advantage of record-low issuance yields. Companies are now turning their attention to debt that will mature in the future and wondering how best to manage interest rate risk around those refinancing plans. Consequently, pre-issuance hedging has become more popular in 2020 than ever before.

Pre-issuance hedging occurs when a company enters into a derivative to lock in the base interest rate of a future debt issuance. For example, a firm that intends to refinance debt in June 2022 by issuing a 10-year unsecured bond faces the risk that 10-year treasury yields or swap rates may increase over the next seven months. On a 10-year issuance worth $1 billion, a 25 basis point (bps)—i.e., 0.25 percent—increase in rates would raise interest expense by $25 million over the life of the financing.

In the current low-rate environment, some CFOs and treasurers question the likelihood that rates will trend higher in the near term. However, markets have been volatile over the past few months, for both short and longer tenors. Thus, many believe there is a greater risk that rates will increase than that they will decrease.

If a treasury group makes the strategic decision to lock in current rates, the questions turn to tactics. First, the finance team needs to determine how much flexibility they require in their pre-issuance hedge. For example, is there uncertainty around issuance timing, size, and underlying tenor? Will the company have multiple issuances? The more flexibility the company desires, the more challenging the hedge will be to structure. If, for instance, a company is undecided between a 10- or 30-year issuance, the treasury group is unlikely to find a hedging structure that can simultaneously mitigate risks inherent in both tenors.

When evaluating the flexibility available in hedging instruments, treasurers should keep in mind that the anticipated timing of the financing is critical. Companies hedging risk in the next three months may have more alternatives than those looking to hedge risk out for a longer term, since different derivative instruments have different pricing efficiencies based on tenors.

A forward-starting interest rate swap is the most common hedging structure for mitigating interest rate risks posed by upcoming issuances. The swap becomes effective on the expected issuance date, with an underlying tenor matching the anticipated issuance tenor. Often, the swap also includes a mandatory early-termination clause aligned with, or very near, the effective date. At issuance, the swap is terminated, and the value is settled up front.

If a company hedges the full value of a $1 billion, 10-year future issuance, a 25 bps increase in rates would make the swap an asset worth roughly $20 million to the company. This asset value would then offset the interest rate that the company pays over the coming decade on the new issuance, which would be 25 bps higher than today's rate.

Companies commonly seek to apply hedge accounting to their pre-issuance hedges. Without preferred hedge accounting, the organization would be required to use over-the-counter (OTC) derivative accounting, and so to record the changes in value of the financial instrument in the income statement each quarter. If rates increased by 25 bps one quarter, then decreased by 50 bps the following quarter, the company would experience a $20 million gain the first quarter and then a $40 million loss the following quarter.

Instead of recording these earnings fluctuations, the company can instead apply the guidelines under ASC 815 (formerly FAS 133) to defer gains and losses from changes in value of the derivative into Other Comprehensive Income (OCI) on the balance sheet. At the time that the underlying debt is issued and the hedge is terminated, the resultant value of the hedge is amortized over the life of the financing. Applying hedge accounting becomes preferable because the company reduces volatility in earnings from hedge date to issuance date, and because the company can amortize the gain or loss at termination over the life of the debt issuance.

Unfortunately, the ability to apply hedge accounting for pre-issuance trades is nuanced. Companies must have some certainty regarding issuance timing and structure prior to the execution of the hedge transaction. In addition, if a company applies hedge accounting and then ends up not issuing the underlying debt after all, it will be forced to recognize the full change in value of the derivative immediately within its earnings. Another risk is that a pattern of missed forecasts may impair the company's ability to apply hedge accounting to similar transactions in the future.

Regardless, the prospective benefit of pre-issuance hedging is abundantly clear: Companies have the opportunity to lock in today's historically low base rates to provide certainty around the interest expense of a future debt issuance.

2. Can our FX hedging program weather today's volatility?

Dollar volatility has caused many companies to re-evaluate their FX hedging programs—both cash flow and balance sheet hedging. Chatham Financial's study of over 1,400 companies' 2018 public filings, "The State of Financial Risk Management," found that more than half of all U.S.-based multinationals have an FX hedging program in place. And our recent client conversations have made clear that many on the sidelines have begun to question whether it makes sense to continue bearing FX risk in light of the dollar's response to the pandemic.

Companies that cheered the strength of the dollar in March and April are now lamenting its weakness. Those that are benefiting from today's weakness wonder if it will persist throughout 2021, as investors may refocus on earnings once the immediate effects of Covid-19 are past. Those without an FX hedging program are evaluating the benefits and costs of implementing such a program in time for 2021, while those that implemented a consistent and disciplined program a year ago are experiencing the removal of noise and volatility that the program was intended to achieve.

For some with existing programs, though, recent volatility has highlighted issues ranging from ineffective identification of exposures to poor execution of a well-thought-out strategy. Some businesses that were hedging only a subset of exposures have realized the risk of having incomplete data sets. These companies may now be diving deeper into their systems and processes to better aggregate data. Others that have been hedging all (or nearly all) of their exposures have started questioning whether they can obtain similar outcomes with less settlement exposure and forward-point costs. Some of these are moving to optimized hedging programs wherein they focus their energy and effort on the exposures that contribute the most to their risks. In many cases, the chief contributors to risk in a company's global footprint have changed over the past year, due to updated exposure forecasts, increased volatility across currency pairs, and changing correlations within the portfolio.

Many companies running cash flow hedging programs have recently expanded those programs into areas such as forecasting and hedge accounting. The global response to the pandemic materially impacted corporate forecasts, from supply-chain disruptions to end-customer demand. Increased forecast volatility has led many companies away from simpler hedge accounting approaches, such as critical term match, and toward more robust and forgiving approaches, including regression analysis. While initially intimidating, platforms allowing for automation of the necessary analysis have created greater streamlining of FX cash flow hedging programs for most organizations.

Most important, forward-thinking treasurers and CFOs have used this crisis to review and improve their financial risk management programs. Even those programmatic hedging programs that have continued to perform post-crisis may have cracks in their foundations, and a comprehensive review ensures greater confidence from investors, the board, senior management, and other executives throughout the company.

3. Are we effectively explaining our hedging program?

Treasury professionals commonly struggle to consistently articulate the objectives and outcomes of their hedging program. Often, this leads to unwieldy presentations with a new slide for every follow-up question from someone in another part of the organization. The data powering these presentations resides in numerous spreadsheets that only a few individuals know how to manage. Over time, treasury staff spend many hours updating presentations and crafting answers to casually worded questions from senior management or board members, with relatively little feedback on the effectiveness of their communications.

The Covid crisis, like the Great Financial Crisis, has led to increased questions for treasury from across the company—including questions about the effectiveness of hedging programs for FX and other financial risks.

Treasurers are increasingly leveraging powerful business intelligence tools that allow them to gather data from multiple sources, then generate dashboards and visual depictions of that data to drive decision-making. Even better, these dashboards are interactive. If the CFO wants to understand why the company's euro exposure changed so much within the past month, treasury staff can simply click on the exposure drilldown to obtain the answer. Consider these business intelligence tools to be the graphical equivalent of PivotTables within Microsoft Excel.

What benefit would the treasury team gain by adding another tool? Ultimately, business intelligence tools enable automated, interactive reporting, so they can reduce days of manual work into minutes. In addition, these dashboards enable interactivity in a way that slides simply never could, so treasury staff can focus on their critical day-to-day and strategic work without having to chase down answers to every potential question. In a short-staffed function, facing today's highly volatile external environment, it makes sense to prioritize the most impactful activities. Business intelligence supports a focus on work that adds higher value.

Taking the Long View

Understanding and then implementing any of these strategies and tactics takes time. In most cases, senior stakeholders must invest time, as well, even as they are managing multiple other priorities. However, the Covid crisis might represent an opportunity to rethink financial risk management in ways that will last far beyond the current moment. An investment now may improve the organization for years, if not decades, to come.

Treasury is experiencing greater visibility among the company's senior executives and board members, as today's volatile markets bring sometimes uncomfortable attention to FX, interest rates, and other risks within treasury's purview. However, with that discomfort comes a real chance to gain support for improvements, especially since those changes will likely benefit the organization immediately. Savvy treasurers can take this opportunity to address their organization's need to manage volatility while continuing to build an efficient, resilient treasury program that positions the organization to weather the next, unknown crisis down the road.

Amol Dhargalkar is a managing director for Chatham Financial who leads the firm's Global Corporate Sector, serving companies focusing on interest rate, FX, and commodity risk management. He earned his B.S. in chemical engineering and economics from Pennsylvania State University and his MBA from The Wharton School at the University of Pennsylvania, where he was a Palmer Scholar.