Corporates eye cross-currency swaps as Euribor sinks

The European Central Bank cut its benchmark interest rate to 0.05% in September 2014, tempting some corporates to swap their debt into euros and cut their debt service costs. But some see hidden dangers

Of note: low interest rate environment creates potential for windfall savings in debt service costs for corporate borrowers

Since the current period of low interest rates began, much of the discussion has centred on the difficulties the buy side faces in generating yield for investors. For corporate borrowers, though, it creates the potential for windfall savings in their debt service costs.

Not only can they finance themselves at historically low levels generally, but a recent cheapening of cross-currency swaps by up to 30% has enabled some to synthetically convert their debt into euros to take advantage of ultra-low interest rates in the eurozone. That's the pitch from dealers, at least.

It's a strategy with obvious appeal, and that on its own is enough to turn off some corporates. A treasurer at one large European company dismisses it out of hand: "There is no free lunch. We don't like to gamble on currencies here."

Bank backers of the strategy insist it is not gambling if a company also has euro-denominated revenues – a natural hedge for any strengthening in the euro.

"People are really looking at this. If, for example, a US company with euro assets has an opportunity to finance in euros, the cost of funds can be 1.5 percentage points cheaper than in US dollars. Matching financing to the currency of the assets also reduces their currency exposure and balance sheet volatility. Both impacts can have a direct and significant impact on a company's earnings per share," says Chris Rees, co-head of the debt capital markets and risk solutions group for Europe, the Middle East and Africa at Barclays in London.

One of our UK clients converted sterling debt into euros, resulting in a 1.5% decrease in their interest costs on that portion of debt

It's easy to see how. As of mid-February, the 10-year US dollar swap rate was at 214 basis points while the corresponding euro swap rate was at 70bp, a trader at one European bank notes – an interest rate differential of 144bp.

Illustration

In a simple illustration of the mechanics, a corporate that had issued a $1 million bond, would lend that principal amount to a dealer at the outset of the trade in exchange for €880,000 – an exchange rate of 1.13. The corporate would receive US dollar Libor interest payments from the bank, covering the interest payments due to its bondholders, and would pay the lower Euribor rate plus a cross-currency spread. At maturity, the corporate would receive its $1 million back in exchange for the €880,000 at the original 1.13 spot rate.

The swap exposes the corporate to interest rate and foreign exchange risk. With eurozone rates unlikely to move anytime soon, given recent gloomy economic data, forex risk is arguably the key exposure – if the euro strengthens to, say, 1.50 during the life of the trade, the company would be exchanging its euros for dollars at maturity using a very unfavourable rate.

Banks say the simplest way to mitigate the risk is to look for a natural hedge with euro-denominated revenues.

"In that case, it would make absolute sense for a company to say ‘We probably should have some of our debt in euros'. Your euro profits become a natural hedge, allowing you to service your euro debt, while at the same time benefiting from the lower interest rates. That could be a perfect foreign exchange hedging policy, and at the same time the company can benefit from lower interest rates," says Karlien Porre, a director in the treasury advisory team at Deloitte in London.

For some banks, the absence of this hedge can be a dealbreaker. "One example last year involved a client swapping fixed dollar debt into fixed euros. In this instance, the rationale of creating synthetic euro debt to take advantage of the interest rate differentials was certainly supported by the quantum of euro assets, as well as their euro earnings," says Richard Cope, a director in bank risk management solutions at Lloyds Bank Commercial Banking (LBCB) in London.

Swap cost 

Until recently, another big obstacle was the cost of the swap, which involves an exchange of principal at maturity and therefore carries a significant amount of counterparty risk throughout the life of the contract – trades can run for 10 years or more in some cases. Given that corporates tend to transact on an uncollateralised basis, banks would face the full capital hit from that exposure, including Basel III's credit valuation adjustment (CVA) charge for future changes in derivatives counterparty credit risk.

But banks and their customers have become increasingly savvy at bringing down these costs.

Philip Stott, part of the fixed-income derivatives team at Citi in London, says he's seeing more corporates willing to sign credit support annexes to cover their cross-currency swaps.

The inclusion of mandatory and mutual break clauses – allowing one or both sides of the trade to close out at a specific point – also means dealers only have to hold capital against the trade up to the break in some circumstances (Risk March 2012).

Periodic forex rate resets can also bring the mark-to-market close to zero. The resets involve regular settlement of the current mark-to-market on the trade. This reduces credit exposure, and some banks believe it also allows them to only calculate the potential future exposure of the trade up to the reset point, reducing the trade's overall leverage exposure.

In other cases, the final exchange of principal can be replaced by foreign exchange options instead – although this approach has been applied mostly in leveraged buyout situations (Risk February 2014)

"The cost has tightened enormously. Before, there were regulatory changes in the way the CVA costs were calculated and banks were not quite aware of the impacts of that in the balance sheet, so initially the swaps were quite overpriced. But now banks are more aware of the regulatory impact and are able to give very similar prices, much more than they used to," says a corporate solutions expert at a European bank.

The overall impact on corporate results can be impressive, say dealers. Antoine Jacquemin, global head of the market risk advisory group at Societe Generale Corporate & Investment Banking in London says that for US dollar versus euro trades, corporates can save up to two percentage points per year on their funding costs.

David Clapham, head of corporate risk advisory at Commerzbank in London says the lower funding costs can also help smooth out earnings: "One of our UK clients converted sterling debt into euros, resulting in a 1.5 percentage-point decrease in its interest costs on that portion of debt. The reduction in earnings volatility was around 9%," he says.

So, if the savings are as great as the banks are claiming, why aren't all corporates doing it? For one, it's not suitable for every corporate. Non-financial corporates don't just enter into these trades for the carry, banks say, despite the potential for savings – they need to have euro-denominated assets or revenue, or it would be too speculative for a regular corporate's risk appetite.

"It's not a massive raft of deals that we're seeing happen, partly because the situation that would allow corporates to do this is reasonably narrow. It's the multinationals that it's really relevant to, since they have the ability to have debt in euros, sterling or dollars, and to some extent have the freedom to choose where their debt sits," says LBCB's Cope.

It's also unlikely that a corporate would want to swap all its debt into euros, he says, especially if it's a multinational where revenues come in a variety of currencies.

"I think it's very unlikely that a potential saving of 1.5 percentage points is going to trigger a wholesale change of debt mix. Most treasury departments have limitations they have to work within, so while they may have sufficient assets to support moving 100% of debt into euros, few would actually countenance a wholesale switch of debt into euros. They may rather choose to temper their debt mix against the split of revenues and assets in other jurisdictions," says Cope.

Forex risk

Corporate treasurers say much the same. Six contacted by Risk said such a move would not be in line with their risk management policies, given the forex risk involved.

"Most corporates I have contact with are very conservative with regard to risks in their financing activities. Even if you could make a profit from lower interest rates, there is still a forex risk," says a senior treasurer at one European corporate.

One London-based risk management consultant points out that a bank may decide to exercise a break, leaving the corporate unhedged. Another notes the structure can take away a company's flexibility to repay its debt ahead of schedule.

"What happens if they need to pay the debt early, as a result of refinancing or restructuring? Cross-currency swaps are credit-intensive, they can be an asset or a liability, and the resulting breakage costs can be significant. There are potential risks that could prove very uncomfortable," says Jonathan Lye, a director at financial risk management consultancy JC Rathbone Associates in London.