Insights from Chatham Financial about pre-issuance hedging and tail risk.
Companies that anticipate issuing debt should not underestimate the Federal Reserve’s resolve to fight inflation, Chatham Financial executives told members of NeuGroup for Mega-Cap Assistant Treasurers at a recent meeting sponsored by the risk management advisory and technology firm.
- In light of the Fed’s determination to get inflation back to 2%, Amol Dhargalkar, Chatham’s managing partner and chairman, raised several issues for treasuries to consider as they lay the groundwork for debt offerings.
Factor in tail risk. Interest rate increases in the US have already exceeded a move of two standard deviations compared to what was anticipated a year ago, Mr. Dhargalkar said, and several factors make more unexpected moves possible.
- Given the risk that rates could move significantly higher, Chatham recommends placing extra emphasis on considering the potential for tail risk and hedging it.
- “We’re not trying to say that rates are going to 7% or 8%,” he said. “But in your scenario analysis and planning, we highly recommend you spend a bit more time on the tail risk scenario.”
- One factor not yet priced into the market, he added, is China at some point eliminating its “zero-Covid” policy. That may reduce supply chain bottlenecks but also “reinvigorate the local economy, stimulating demand across the country, thereby increasing demand for a variety of raw and finished goods.”
- That includes “increased energy consumption that can drive oil and gas prices higher in the short term, further stoking inflationary concerns across the global economy.”
Pre-issuance considerations. More sophisticated approaches to gauging the impact of rate increases, including Monte Carlo simulations or statistical shocks to forward curves, may be warranted, rather than a static analysis of rates rising by a certain amount, Mr. Dhargalkar said.
- Pre-issuance hedging remains popular because companies can de-link the underlying rates at the time of issuance from the rates locked in through hedging, he added, noting that in a volatile market dollar cost averaging the hedge can help lower future issuance costs.
Debt offering anyone? Responding to a query about how members plan for future debt issuance in light of today’s rate risk, a few members mentioned management’s tight controls.
- One said her company pursues relatively short-term pre-issuance hedges, and only if senior management judges the offering eligible for hedge accounting.
- “I would add that if you’re doing [pre-issuance hedging] for the first time it’s really good to be right, since it puts everyone at ease that going ahead this will be an asset and not a liability,” she said.
- Mr. Dhargalkar added that in order to manage expectations internally, it is important to help stakeholders understand the intent of hedging to create predictability in outcomes.
More to read on pre-issuance hedging. To read a 2020 NeuGroup Insights article on pre-issuance hedging based on analysis from Chatham, click here. And to see an article on the topic by Chatham published earlier this year, click here.