Interest Rate Hedging Best Practices & Pitfalls to Avoid March - PDF document

3/16/2017 Interest Rate Hedging Best Practices & Pitfalls to Avoid March 14, 2017 @ SVAFP & INTEREST RATE Ruth Hardie rhardie@hedgetrackers.com 1

3/16/2017 Agenda • Risk Mitigation Scenarios focused on • Fixing variable interest expense • Locking in the fixed rate of bonds/notes • Typical Instruments • Swaps • Caps • Pitfalls to Avoid IR Risk Mitigation Scenarios 2

3/16/2017 Risk Mitigation Scenarios “Faced with the threat of rising interest rates, plenty of chief financial officers are wrestling with whether to issue fixed- or floating-rate debt. That’s because even small fluctuations in interest rates can cost or save a company millions of dollars in interest expenses. The decision hinges partly on rate expectations. With unexpectedly strong economic growth in the third quarter and falling unemployment, some CFOs predict that the Federal Reserve will detect inflation and raise short-term interest rates sooner than it has telegraphed. On the flip side, business investment and inflation remain decidedly weak, so some finance chiefs believe the Fed will stick to its message and won’t raise rates before at least 2015.” WSJ Jan ‘14 Risk Mitigation Scenarios • Fixing variable interest expense • Term loans, revolvers • Lock in the fixed rate • Bonds, notes 3

3/16/2017 Interest Rate Curves – Less Than 3 Yrs 85 bps Interest Rate Curves – 4 Yrs & Up 100 bps 4

3/16/2017 IR Terminology Cheat Sheet Benchmark Int Rate - LIBOR, Treasuries, OIS Cap - One party receives int when LIBOR > X% - other party receives a premium Cash Flow Hedge - Protects future cash flows from changes in interest rates Contemporaneous - Hedge accounting documentation requirement (within 2 business days) Effectiveness - Changes in the hedge offsetting changes in the hedged item IR Swap - Two parties exchanging interest - one pays fixed and other pays floating MTM - Mark to market (i.e. the value at a certain date) - Probable - > 80%, Possible 20-80%, Remote < 20% Probability - The option to enter into an IR Swap Swaption Fixing Variable Interest Expense LIBOR Fixed L I B O R 5

3/16/2017 ASC 815 Basics • Derivatives must be MTM and the default is to record the offset in the P&L • Hedge accounting is a privilege • Cash flow hedge accounting allows you to defer derivative effective gains/losses • Ineffectiveness on a cash flow hedge is recorded when the derivative outperforms the hedged item Typical Instruments 6

3/16/2017 Swap Construction 13 Vanilla IR Swap Mechanics 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed A pays B fixed A pays B fixed A pays B fixed interest on $10M interest on $10M interest on $10M interest on $10M A receives 3M A receives 3M A receives 3M A receives 3M LIBOR interest on LIBOR interest on LIBOR interest on LIBOR interest on $10M $10M $10M $10M 14 7

3/16/2017 Net Impact of Swap (@ Trade Date) The red arrows represent Fixed payments to the counterparty The black arrows represent predicted LIBOR payments to the Company 15 Swaps Pros Cons • Predictability • Lose the ability to benefit from low rates • No upfront cash required • Locked into a single tenor* • Liquid market • Locked into a minimum • Customizable borrowing • Loss up to fixed rate 8

3/16/2017 Success Stories – Construction/Term Loan Commercial Ops - 4.46% 5.000% Fixed Rate 3.46% 4.000% Profit Lockedin at 1% 3.000% 2.000% Actual LIBOR Rates 1.000% 0.000% 3/1/2014 3/1/2015 3/1/2016 3/1/2017 3/1/2018 3/1/2019 3/1/2020 3/1/2021 3/1/2022 3/1/2023 3/1/2024 3/1/2025 3/1/2026 3/1/2027 3/1/2028 3/1/2029 3/1/2030 3/1/2031 3/1/2032 3/1/2033 Success Stories – Fixed Debt Replacement $100MM Bond @ 2% 2.500% 2.000% $3.6M savings locked in 1.500% 1.000% $1.4M received, $2.4M 0.500% paid 0.000% 3/1/2014 5/1/2014 7/1/2014 9/1/2014 11/1/2014 1/1/2015 3/1/2015 5/1/2015 7/1/2015 9/1/2015 11/1/2015 1/1/2016 3/1/2016 5/1/2016 7/1/2016 9/1/2016 11/1/2016 9

3/16/2017 Success Stories – Rate Lock – 6 months 2.50% $920k on $20M over 10 2.20% years Delta - 2.00% .51% 1.69% 1.50% 1.00% 0.50% 0.00% Exit price Lock Cap Construction Cap Strike 20 10

3/16/2017 Vanilla IR Cap Mechanics 12/31/X0 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed Premium A receives 3M A receives 3M A receives 3M A receives 3M LIBOR interest > 1% LIBOR interest > 1% LIBOR interest > 1% LIBOR interest > 1% on $10M on $10M on $10M on $10M 21 Net Impact of Cap (@ Trade Date) The red arrows represent premium paid to the counterparty The black arrows represent predicted fair value of each caplet 22 11

3/16/2017 Caps Pros Cons • Can benefit from low rates • Cash outlay • Predictability above a • Less transparent pricing threshold • Harder to value • Customizable • Locked into a single tenor* • No credit charges • Locked into a minimum • Loss limited to premium borrowing paid Success Stories – 2% Cap $100MM hedged for 2,500,000 $400k savings 4.5 years. Currently 17 2,000,000 months into the hedge. Last reset rate was 1,500,000 .78% 1,000,000 500,000 - Premium Savings to date 12

3/16/2017 Pitfalls to Avoid Pitfalls – Floating Rate Debt 13

3/16/2017 Pitfalls – 0% Floors Cumulative Ineffectiveness $800M amortizing debt hedged over 4-13 years Pitfalls – Future Fixed Rate Debt • Blackout Periods • Hedge window • Other fixed rate debt • Swaptions 14

3/16/2017 Pitfalls – Future Fixed Rate Debt 200000 Extrinsic 180000 Net Value $15,200 Premium 160000 $47,500 140000 120000 Intrinsic 100000 Value 80000 $124,800 60000 40000 20000 0 Swaption Premium Swaption Termination Thank You 1190 Saratoga Ave, Suite 110 San Jose, CA 95129 Direct: (408) 350-8580 www.hedgetrackers.com 15

3/16/2017 CONNECT WITH US CONNECT WITH ME @HedgeTrackers linkedin.com/company/hedge-trackers Ruth Hardie hedgetrackers.com/newsletter Senior Director, Client Services rhardie@hedgetrackers.com hedgetrackers.com/blog linkedin.com/in/ruth-hardie-0b977b3 16