Are Swaps Helping Companies Meet Debt Covenant Ratios? - July 2010

What happens if the swap “rubber band” snaps back?

Swaps are headlining market news because the rates, at some maturities, are lower than the US Treasuries’. This is saying a default-possible rate is lower than the default-free rate, how can this be! We suggest looking for the answer is in companies’ real motivations. We question what will happen to those companies and the rates market when the swap “rubber band” snaps back.

Swaps, or interest rate swaps, are a derivative that can be used to change an existing debt’s interest profile from “fixed” to “floating”, or vice versa.  A “Fixed” interest profile is one where the interest rate, and therefore cash interest, is known (i.e. fixed). “Floating” profile means where the interest rate, and cash interest, references a market index – commonly 3-month or 6-month LIBOR – so the interest changes (i.e. floats) every 3 or 6 months.  A bond with its constant coupon is an example of debt with a fixed interest profile; a loan with its LIBOR + spread interest is an example of debt with a floating interest profile.  The swap can be overlaid on either to change the profile (bond plus swap becomes synthetic floating; loan plus swap becomes synthetic fixed).

Typically companies borrow in a mix of bonds and loans so have a “natural” mix of fixed and floating interest payments. In the current climate, where the bond markets have been re-opening, but the loan market has not as much, companies are re-financing some of their bank debt (and short-term debts too) with bonds. So the natural mix of fixed and floating is weighing more heavily towards the fixed profile.  Borrowers can use swaps to re-balance that mix, which is what they are doing, and as their activity are all on one side of the market (thus the demand-supply imbalance), the result is downward pressure on swap rates (to the degree, as mentioned above, that for some maturities, the rates are below US Treasury yields).

Some market observers have commented on this. What they fail to address is why? Why persist in swapping when swap rates have reverted to an illogical level vis-à-vis the US Treasury? Why persist in swapping when most economists believe that interest rates are inevitably going to have to rise (albeit at some unknown future point) so wouldn’t a borrower be better off keeping the bond’s fixed rate (and not having a floating one)?

We believe it isn’t so much corporate treasurers are ignoring the logic and the future, but that swapping may be helping with a more immediate problem, namely maintaining interest coverage ratios in debt documents. Some debt documents, especially for weaker credits, contain financial covenants of which the most common is interest coverage, for example EBIT / interest expense > X (or EBITDA / interest expense > X). Breach of the covenants could result in the debt becoming due and repayable immediately, or certainly giving creditors the legal clout to demand a corporate restructuring. Clearing the ratios is less easy in a recession.

Currently the US yield curve (and that of most major currencies) is upward sloping meaning short-term rates (such as 3- and 6-month LIBOR) are lower than the longer-term ones (such as 5-year). A borrower issuing a 5-year bond would be paying a coupon rate higher than if he were paying based on a 3-month rate instead. By using a swap, the borrower – well – swaps that 5-year rate for the 3-month rate. The interest expense is lower by the differential and the EBIT/interest expense ratio is eased.

It is a clever way to buy some head room especially if those interest coverage ratios are tight and banks and shareholders are breathing down necks asking about clearance. There is a risk of course. It is that short-term interest rates rise faster than EBIT does. How likely is that to happen? That question may be split into separate smaller questions. Short-term rate changes tend to be driven by central bank activity in the first instance, when will the Fed Reserve tighten, and how far are they likely to go and how fast? (A look at history gives some guidance). Market expectations then carry the momentum of the change: will the current imbalance in trading one side of the swaps sharply correct itself (as companies unwind their swaps) leading to an even faster rise in short-term and long-term rates? Which companies’ EBITs can follow at the same pace? Which companies can’t?

The corporate financier and risk management advisor may wish to discuss this potential problem with their clients and think of a Plan B to address the potential weakness of the current Plan A for coverage ratio maintenance. The creditor even when the debtor’s interest coverage ratio is in compliance may not want to relax too much: is compliance because EBIT is solid or because interest expense has been synthetically lowered? Swaps traders and sales may want to consider corporate performance as a potential driver of swap paying/receiving demand.

AMT offers classes in capital markets including debt products and interest rate swaps as part of its investment banking suite of classes. We are also pleased to offer corporate valuation and credit analysis for sales & traders. Please contact us for more information.