Mar 3, 2023
A Quirky Bond Trade Is Giving Companies a Back Door to Cut Borrowing Costs
(Bloomberg) -- Companies are taking advantage of price discrepancies in debt and derivatives markets that give them a way to trim their borrowing costs. Investors eager to take advantage of rising interest rates are buying the debt even if they only earn the extra yield for a year.
A raft of investment-grade companies have sold bonds this year in the US that allow issuers to buy back their securities if rates drop enough for refinancing to make sense, an uncommon feature for high-grade notes. The debt usually matures in three years and typically allows companies to repurchase the bonds, an option known as calling the securities, after 12 months.
In 2023, investment-grade firms have sold $8.6 billion of the bonds known as “three-year noncall one bonds,” or 3NC1s, according to data compiled by Bloomberg News. That’s about 50% more than were sold all of last year. Recent offerings have come from well-known corporations including telecommunications firm AT&T Inc., pharmaceuticals company Eli Lilly & Co., biotech firm Amgen Inc. and tool maker Stanley Black & Decker Inc.
Read more: IG ANALYSIS: IBM, Elevance Lead Docket; 3NC1 Structures Return
Because of a quirk in interest-rate markets, companies selling 3NC1s can cut their borrowing costs dramatically by hedging with derivatives alongside their bond offering, according to a report this week from research firm CreditSights Inc.
As part of such a transaction, the company needs to enter into a trade known as an interest-rate swap with a bank, which essentially turns the bond the corporation issued into a floating-rate obligation, similar to a loan, CreditSights strategists led by Winnie Cisar wrote. The swap needs to have a particular feature: the bank needs to be able to cancel it any time after a year, an option similar to the company’s right to buy back its bonds after a year.
“There’s a strong likelihood that investment bankers and debt capital markets teams are out pitching these transactions with the swap,” Cisar said in an interview on Friday.
The transaction can also make sense for the issuer as a cheaper way to fund than getting a term loan. Like a loan, the callable bond can be refinanced before maturity.
In a hypothetical example that CreditSights looked at, a company that sold a 3NC1 at a 4.9% coupon could slice 0.6 percentage point a year off its annual interest costs by entering such a swap, compared with just issuing a conventional three-year fixed-rate bond that can’t be bought back. In the end, it would be borrowing at less than the Secured Overnight Financing Rate, an unusually low price for a company.
The funding benefit stems from current differences in how bond markets value a company’s right to call its debt, compared with how derivatives markets value the right for the bank to cancel the swap. Both are essentially interest-rate options, but that option is more expensive in the derivatives markets than in the bond markets.
In this transaction, the company is essentially buying the option from money managers when it issues debt, while selling the option to Wall Street firms when it enters the cancelable swap.
The differing valuations stem from another feature of markets now: short-term rates are higher than long-term rates, known as an inverted yield curve. Investors are clamoring for short-term bonds that pay higher yields, and many are happy to effectively sell options to companies in exchange for even higher interest payments.
Money managers are often happy to own bonds from high-quality issuers they are already exposed to. Even if the securities are called after a year, they will have received relatively high interest payments.
“Because of the extreme inversion in the yield curve, the value of the cancelable swap is significantly higher than the premium that bond investors are charging for the call option,” said Maureen O’Connor, global head of high-grade syndicate at Wells Fargo & Co.
It’s hard to know for sure if companies are electing to enter swaps, because they often don’t disclose these derivatives until their next quarterly filing, according to CreditSights. Last year, of all the companies that issued 3NC1 securities, only one disclosed an interest-rate swap, the research firm said: General Mills Inc. Amgen, AT&T, Eli Lilly and Stanley Black and Decker declined to comment.
And there are risks for companies in taking advantage of this arbitrage, according to both CreditSights and bankers that have looked at these deals. For example, if the economy suffered a tough recession, interest rates could fall, while corporate bond risk premiums, or spreads, widen substantially.
The company would probably then find its swap getting canceled by its bank. But with wider spreads on its debt, it might not be able to save money by refinancing its debt, leaving it stuck with a fixed-rate obligation. It might have been better off in this scenario issuing non-callable bonds, perhaps with a longer duration, CreditSights wrote.
(Updates with additional details on trade throughout.)
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