Faced with the threat of rising interest rates, many CFOs are wondering whether to issue fixed or floating rate debt.
This is because even small fluctuations in interest rates can cost or save a business millions of dollars in interest charges.
The decision depends in part on rate expectations. With surprisingly strong economic growth in the third quarter and falling unemployment, some CFOs expect the Federal Reserve to detect inflation and hike short-term interest rates sooner than it wired. On the flip side, business investment and inflation remain decidedly low, so some CFOs believe the Fed will stick to its message and won’t hike rates until at least 2015.
âThere’s a pretty divided community about this,â said Amol Dhargalkar, managing director of Chatham Financial in Kennett Square, Pa., Which advises companies on corporate finance.
Investors have taken to floating rate bonds because they offer protection against rising rates. Coca Cola Co.
, Johnson & Johnson,
and Bank of America Corp.
were among the companies that sold floating rate debt in the fourth quarter. Floating rate bond issues totaled $ 171 billion last year, more than double the $ 65 billion sold in 2012 and the highest level since 2007, according to data tracker Dealogic.
For companies, these bonds can reduce borrowing costs and diversify their investor base. The risk, however, is that if interest rates rise faster than expected, a business will pay more than if it had sold fixed rate debt.
Level 3 communication Inc.,
a Broomfield, Colo.-based telecommunications company sold $ 300 million of high yield floating rate debt in November. The deal allowed Level 3 to refinance a more expensive floating rate note and lower its interest charges, said Sunit Patel, executive vice president and chief financial officer. About 65% of the company’s debt is fixed rate.
Level 3 chose a floating rate debt issue because they expect interest rates to rise slowly over the next two years, and it is easier to refinance variable rate debt than debt at fixed rate, Patel said.
If interest rates rise, “we can refinance some of our fixed rate debt at lower interest rates,” since Level 3 expects its credit rating to improve, Mr. Patel.
At Fifth Third Bank, a unit of Fifth Third Bancorp based in Cincinnati,
Corporate clients tend to be mid-sized businesses that rely on variable rate bank loans for funding rather than bonds. The difference between a variable rate loan and a fixed rate loan can be a percentage point or more, which can make it too expensive for CFOs to switch to a fixed rate.
âThey want to stay afloat for as long as they can because the savings they get from floating are very significant,â said Bob Marcus, the bank’s head of capital markets.
Most issuers still lock in their interest rates with fixed rate debt. Firms issued nearly $ 202.8 billion in fixed rate bonds in the fourth quarter, and in the first three weeks of January they sold an additional $ 54.8 billion, five times the value of the bonds. variable rate, according to Dealogic.
âIf you think rates are going to go up, why go free float? Said Brian Kalish, director of the Association for Financial Professionals.
A fixed-rate fan is Aldo Pagliari, the CFO of toolmaker Snap-On Inc.,
in Kenosha, Wisconsin. The company had $ 980 million in debt at the end of the third quarter, all at fixed rates except for a $ 100 million interest rate swap that will last until 2019, did -he declares.
Pagliari believes rates will rise over the long term, but remain low by historical standards. If Snap-On were to issue a 10-year note today, it would likely return around 4.1%, which is still lower than the company’s 5.6% average blended return on its outstanding debt, he said. -he declares.
Nonetheless, appetite for floating rate bonds remains strong, with issuance in January matching the pace of last year, according to Dealogic. Even the US Treasury is expected to issue $ 15 billion in new floating rate notes on Wednesday, and demand is expected to be strong.
Greg Hart, head of North American corporate rate origination at Bank of America, explains that a typical large company with a quality rating aims to have between half and 80% of its debt at fixed rates. But some CFOs took advantage of years of historically low rates and issued a lot of fixed rate debt. In the bank’s annual customer survey, 57% of companies said they had a debt target within this range, but only 42% said they met that target.
To restore the ratio, “the most common method is to use a fixed-to-floating interest rate swap” on one of the company’s outstanding fixed-rate bonds, Hart said. CFOs can also refinance fixed rate debt with variable rate debt or extend the term of cash investments by switching to longer-term treasury bills, he said.
When Avis Budget Group Inc.
issued $ 250 million in high yield floating rate debt in November, the Parsippany, New Jersey-based car rental company hedged some of its interest rate exposure on the deal, fixing its rate payments, company spokesman John Barrows said. During the year, the company froze rates on $ 2 billion in debt, he said.
“We continue to view interest rate risks as asymmetric,” said Barrows. “The potential for rate hikes exceeds the potential for rate cuts.”
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