To hedge or not to hedge

With UK interest rates left unchanged at 0.5 percent for the twentieth month in a row by the Monetary Policy Committee in November, British American Tobacco (BAT) group treasurer Neil Wadey says that his company is taking advantage of the low interest rates to lock in a portion of his company’s debt portfolio, which equates to close to £10bn.

In the nine years that Wadey has been working in BAT’s treasury operations, he says he has never seen a situation where there are both low interest rates and a low spread, or margin, on the official rates such as Libor, that his company would pay.

“At different times there have been low rates and a wide spread, or vice-versa, or even both wide simultaneously, but right now through a combination of the slow economic conditions and (quantitative easing) they are both low,” says Wadey. “It’s an attractive time to lock in long-term rates. Most treasurers, unless they’ve got particular short-term considerations, will be locking in at these levels.”

Banks and bonds

BAT obtains about 20 percent of its debt through banks, which is most of its short-term consideration, and 80 percent via the bond market. It is in the latter area where it actively engages in hedging. And in order to hedge, Wadey says his company does not gaze into the crystal ball and predict economic conditions; rather, it relies on where the yield curve sits in relation to average market conditions over the past 10 years.

Another important point about BAT is that the company does not use exotic derivatives, according to Wadey, but issues debt regularly and at that point decides whether to go fixed or floating.

“In the short term, we are looking for certainty, so we’re pretty fixed for the next 18 months, and in the long term we look for efficiency,” he says. “Some companies float everything and fix the parts they want to fix. When we do a piece of debt issuance, we look at the maturity profile, the currency need, and make a decision.”

Last summer, for example, BAT conducted a sterling issue for about five percent of its debt book, which it kept in a fixed format, according to Wadey. Such a process of managing his book in relatively small amounts has a “natural averaging” effect to his debt portfolio, which incidentally has a maturity average of seven years and goes out to 2040.

Wadey is just one of the senior members of companies’ finance departments that Financial Director interviewed in relation to their interest rate hedging policies and how they are being affected by the conditions of low interest rates and low spreads.

BAT was anomalous because it emerged from the credit crisis relatively unscathed, but all the executives spoken to indicated in some way their thoughts are turning to when exactly interest rates could rise, and what effect that will have on the company’s debt, or net cash, profile.

After all, the abnormal state of credit markets is such that in October and November the US Treasury sold bonds with negative interest rates for the first time and Goldman Sachs sold its first 50-year debt deal. These events are happening at a time of low interest rates and when the US Federal Reserve is moving towards another round of asset purchases that are aimed at stimulating the economy and preventing deflation.