On August 13, the two-year versus 30-year US treasury yield curve gapped out to a seven-year high of 184 basis points. The two-year treasury was trading at its lowest ever yield in the 25 years since the two-year security was first introduced, and three-month Libor was even lower at 3.57%. Moreover, with the US economy showing no signs of recovery, short-end rates seem set to move even tighter. The extraordinary steepness of the US yield curve has provided mouthwatering swap opportunities for corporates that would not normally consider conversion of fixed-rate liabilities to floating rate. The greater than normal swap business has also put added downward pressure on swap spreads.
For example, on July 27 discount retailer Wal-Mart brought to market a $1.5 billion two-year global and a $1.5 billion five-year global via Lehman Brothers and Goldman Sachs. Although the borrower declined to comment on its debt-market activities, several New York swap dealers say the proceeds of both tranches were swapped to floating-rate dollars.
The 5.45% five-year notes were priced at 84bp over treasuries or 3.5bp over mid-swaps. At the time, three-month Libor was 3.7%, so by swapping into floating rate Wal-Mart could secure funding of about 3.75% until the first reset, compared with fixed-rate funding of about 5.42%: a difference of almost 170bp.
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Two weeks earlier, EOP Operating, a unit of Chicago-based real estate investment trust Equity Office Properties Trust, issued a $1.1 billion 7% 10-year global note and a $300 million 7.875% 30-year global bond. The firm owns and manages office properties and has a portfolio of buildings located in various US states.
The lead managers of the bond deal were BankAmerica Securities, Salomon Smith Barney and JPMorgan. The borrower swapped $500 million of the 10-year tranche to floating rate, achieving a funding level of Libor plus 88bp, confirms chief financial officer Richard Kincaid. Before this issue and the subsequent swap, EOP Operating had no floating-rate exposure, he adds.
That tranche yielded 185bp over treasuries, or 7.14% on a re-offered basis. Yet it was able to secure floating-rate funding at three-month Libor (then 3.76%) plus 88bp, or 4.64%. Consequently, floating-rate funding proved to be some 250bp cheaper to the borrower than fixed-rate funding.
Neither of these two borrowers is a usual or typical user of derivatives. Whenever a bank or financing vehicle, such as GMAC or TMCC, brings fixed-rate debt to the market it is normally a foregone conclusion that the proceeds have been swapped to floating rate to better match assets. But EOP Operating generally offers five-year fixed-rate leases. Normally, only 15% at most of its liabilities are floating rate, confirms Kincaid.
But treasurers of companies like this, who are under increasing pressure to improve the bottom line, find the opportunities afforded by the steep yield curve hard to ignore.
“A greater and greater number of borrowers are considering swapping to floating rate whereas two years ago or so they wouldn’t have thought about it,” says a New York swap dealer. “I would say that about half the corporate flow we have seen over the last month or more has been swapped,” says a senior dealer at a major money-centre bank. “This includes manufacturing companies, energy companies – everyone is finding it attractive.”
In particular, it is the vertiginous front end of the curve that attracts dealers. “Though the curve is very steep, it is in spot Libor to the long end that you see the real difference,” says a trader. On August 14, the differential between three-month Libor and five-year treasuries was close to 100bp; it was only 46bp over the next five years of the curve and then another 53/54bp out to the long bond.
Verizon, a New York-based telecommunications company, which issued a $1 billion 6.5% note due 2011 on August 15, provides another example of the compelling economics of a swap to floating. The firm’s global bonds yielded 153bp over treasuries, or 6.53% semi-annually. With swap bids around 83bp at 10 years at the time, the notes were worth about Libor plus 70bp in the asset-swap market. Thus a swap to floating would secure funding at three-month Libor (3.56%) plus 70bp until the first reset date – 227bp through fixed-rate funding.
The borrower declined to comment on its deal, beyond saying that the proceeds had been raised to replace short-term financing. But New York dealers were convinced that the transaction had been swapped. “They’d be crazy not to swap,” says one.
In an interest-rate swap the fixed- and floating-rate payments are netted out against each other at the end of each three-month period. So in the present environment the payer of floating rate and the receiver of fixed rate receives a rather large cheque every three months. In the case of 227bp of $1 billion that’s $22.7 million.
“Companies like this have to swap to floating. They’re strapped for cash and even though they mark to market the swap they get a really big cash payment every three months,” says a swap dealer.
Of course three-month Libor might, and probably will, climb from current levels, increasing costs to corporates. But this will take some time and does not seem to be a deterrent to the current crop of cash-hungry US corporates. The Eurodollar strip suggests that Libor will still be below 5% in early 2003, and this does not seem at all bearish. Nor are borrowers obliged to keep the exposure in floating rate – they can unwind the position at any time.
“If Libor gets to 5.5%, then they’re breaking even. But this will take a couple of years and by that time they’ve had two years of large payouts. And you have to figure that if Libor does get to those prices then the economy is in better shape, they’re earning money and they don’t care any more. With the economy down here, it is a win/win situation for these guys,” explains dealer.
Kincaid of EOP Operating agrees: the borrowing it conducted in July allowed it to push out the duration of its debt liabilities, leaves its $1 billion credit line untouched and swap to floating at a time of recession. “Floating rate is a great hedge against a weakening economy,” he says.
Moreover, not only are borrowers swapping new debt to fixed rate, outstanding fixed-rate debt is being converted to floating rate. Companies from sectors as diverse as energy, consumer products and manufacturing are showing an interest in swapping fixed-rate exposure to floating rate. “It looks very attractive. We tell these guys: ‘Just do this deal and in three months we give you a cheque for $5 million.’ It’s a pretty easy call,” says a swaps salesman.
Once again, the experience of EOP Operating proves the point. At the same time that it swapped $500 million of its $1.1 billion notes due 2011, it also converted $400 million of its 6.625% bonds due February 2005, issued in 1998, to floating rate at a cost of Libor plus 109bp. This means the borrower is paying 4.85% until the first reset date while, at the close of trading on August 17, its bonds due February 2005 were trading at 5.99%.
These kinds of opportunities have kept the dollar new-issue market relatively busy during the normally torpid months of July and August. Dealers expect that the normally frantic post-summer period in the debt markets will see many more borrowers looking to swap into floating-rate exposure.
This, in turn, should exert downward pressure on swap spreads. In early August, 10-year swap spreads flirted with the low points of the year. They traded at 79bp over treasuries, only a couple of basis points away from the low of 76bp hit in May. Ten-year swap rates, which combine swap spreads and treasury yields, were also near the lows of the year. The 10-year touched 5.74%, just 7bp away from the low-water mark of 5.67% attained in March.
Part of the reason why swap spreads have ground down is the swap business conducted by US corporates. In a swap of fixed rate to floating, a swap counterparty pays the borrower fixed rate to match its coupon payments, and then has to offset the position in the interbank market. The pressure to receive fixed-rate dampens swap spreads. A period of renewed new-issue and swap business in September and October should put more downward pressure on swap spreads and – in lieu of any other developments – take them to the lowest levels seen so far this year.
Of course, the lower that swap spreads trade, the less attractive is the arbitrage to floating rate. But the lowness of rates is such that this is unlikely to be too much of a disincentive to cash-hungry corporates.
