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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.

 

In the UK, the authorities have reduced official interest rates to 0.5 percent, the lowest level in the Bank of England’s 315-year history. There have been a series of interest rate cuts aimed at easing the credit crunch and getting the banks to lend again. Because this has not happened, or at least not at the speed that was hoped, the bank has expanded the amount of money in the system by £200bn through its quantitative easing programme.

A FTSE-250 health company’s finance director says he has adopted a policy of only employing short-term debt to take advantage of the rate.

“We’ve tended in the past to have 40 percent fixed and 60 percent variable but, given the low interest rate and steep yield curve, it’s expensive to fix,” he says. “You could end up paying 2.5 percent for five years, so you would be paying five times as much to lock in for that period. Clearly rates can move up, but if you believe the recession will be extended you can save a lot of money by not fixing.”

He says that when his team believes that rates will start to rise, “then we will start increasing the fixed amount”.

No appetite for debt

After the credit crisis, the credit company’s FD has aggressively reduced the amount of debt on its books and it is by no means alone. Part of the reason interest rates are so low is because there is little appetite from many companies for debt. Certainly that was the case with many of the companies Financial Director spoke to.

Volex is one company that almost went bankrupt, but has now become a market darling, its share price having more than quadrupled in the past year. Its finance director Andrew Cherry says that the cable manufacturer relies on a US dollar and a euro revolving credit facility that rolls over every three months. He renews Volex’s interest rate hedge on the rolled-over amount for the next three months.

Although he says that that the company has hedging policies that it renews every three months, Volex does not have long-term debt, “nor anything especially exotic in terms of hedging”.

Cherry’s comments will be appreciated by the shareholders and management of Premier Foods, which recently announced that it had agreed to spend £167m to end its exposure to toxic derivative instruments that were originally intended to insulate the group from rising interest rates.

The marketer of brands such as Capri Sun, Ocean Spray, Popz and Lyle’s took a bet on rising interest rates to offset the cost of borrowing. When interest rates fell, the strategy faltered, which triggered massive payments. Maturities in some of the swap arrangements were as far ahead as 2037 and some were not hedged against the group’s debts, adding to the financial risks the company faced.

Exposure risk

“The swaps created an unhedged exposure to certain interest rate movements which could have cost the company up to £450m,” Premier Foods said.

The financing arrangements “threatened the viability of the business”, according to Clive Black, an analyst with broker Shore Capital. Such considerations weigh on the minds of many company executives.

Education Development International (EDI) has more than doubled its profits in the past two years, but has achieved this feat without the use of debt.

EDI finance director Paul Bird says that his company will look to reduce £10m of the cash it holds by around two-thirds. Whatever interest rates do, the thought of another financial crisis on top of the cuts in public expenditure are foremost in his mind.

“Now that the world is more stabilised, we are looking for acquisitions, but we will maintain a minimum balance just in case the world doesn’t double-dip,” Bird says.

For the majority of companies outside of the £47bn market capitalisation of BAT, considerations such as access to capital also play a part. As one executive in a listed company told Financial Director:

“The worry for most of us is about getting access to funds, rather than the possible upturn in interest rates. If interest rates do start to rise (which in my view won’t happen in the short term), it may actually lead to more lending.”

In this case, rising interest rates could lead to more debt, not less.

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