The last few years have proven to be extremely challenging for companies issuing debt. Even if a company was lucky enough to find a bank willing to underwrite an issue, the pricing was prohibitive and issuers needed a pragmatic approach. One of the practical ways to get pricing to achieve reasonable levels was to embed credit-contingent features in the deals that would trigger higher coupon payments with the expectation that credit ratings (read credit spreads) widen in the future. This was a fair compromise considering that issuers unable to obtain reasonable pricing often meant going out of business. Now that most markets are back to “new normal” levels and the yield curve is providing some instant “carry,” many of these issuers are looking to swap the issues to floating via receiver swaps. Not so fast my friends! Even though this might make perfect sense from an economic perspective, from a hedge accounting perspective those credit-contingent features need to be factored in to assessments and measurement of ineffectiveness, all thanks to Paragraph 21(f) under FAS 133 (or, if you want to be politically correct, ASC 815-20-55-15).
Now, you might be thinking, why do I need to take into account those credit contingent features if I’m just hedging the benchmark interest rate on my issue? That’s a clear, logical, and coherent thought; however, 21(f) is fairly clear in stating that “Excluding some of the hedged item’s contractual cash flows (for example, the portion of the interest coupon in excess of the benchmark interest rate) from the calculation is not permitted.”
All of the auditors (the technical folks from the National Offices) I’ve spoken with have stated that they believe this means that a company needs to include the probability adjustments that the credit spreads might widen and the coupon might reset in today’s calculation of the mark-to-risk on the bond. Most companies I’ve spoken to and very few banks have the models and know-how to do this. And even if companies could value these issues from a hedge accounting perspective, it might lead them to failing effectiveness assessments altogether, let alone cause more P&L volatility than the positive “carry” they will achieve.
So what’s the solution? Embedding the same credit-contingent features in the “receive” (fixed) leg of the swap, which should bring a smile to the face every derivative marketer! The other solution is to go the FAS 159 route. However, depending on the credit environment, that might give you more P&L volatility than your CFO is willing to take.