(Part 2 of 3)

Two weeks ago we asked the question “Is the best provider of debt likely to be the best provider of an associated hedge?” We posited that from at least three perspectives, the answer is “No.” This is the second of three commentary newsletters exploring this theme. See Part 1

This week’s example is drawn from situations in which it is more efficient to borrow in a foreign currency than in the functional/home currency of a business. Organisations can issue debt in other markets for a variety of reasons, but it is increasingly common for reasonably large companies in countries with only moderate liquidity in their debt markets, sometimes depending on the sector (such as Poland, South Africa, or Switzerland for just a few examples). There is a relatively large “private placement” market in the USA that can be tapped by non-US groups, as well. And for larger deals in the European private equity arena, a non-local debt component in the acquisition financing package is an increasingly common phenomenon regardless of the home market.

The first point to highlight is that without emplacing a fairly conservative hedge on the currency risk of non-local borrowing, any possible efficiency gains afforded by borrowing in the other currency can be eroded very quickly. For instance, the effective cost of such debt can be incredibly high if the principal amount is not hedged appropriately, given that any strengthening in the borrowed currency’s value would effectively increase the principal amount due on repayment on a one-for-one basis.  Almost as importantly, the embedded charges associated with the currency hedging need close monitoring, since if they conspire in the end to be higher than the cost savings, there is not really much point of “going non-local.”

The salient feature of hedging the currency risk of principal balance and interest coupons for non-local debt – usually in a package called a “cross-currency swap” – is that it is very credit-intensive.  Unlike a vanilla interest rate swap (which itself has substantial counterparty risk), the risk profile on a cross-currency swap does not dissipate fully over time.  Because the principal exchange on the scheduled loan repayment date could be fixed at a rate that ends up differing 20-30% from today’s exchange rate (or more), any credit exposure model would factor in substantially higher net exposure with a longer duration than for interest rate hedging.  This may be bad news, but it is not the end of the story.

The capacity of any given bank to take on such credit-intensive hedging will be finite and subject to bank-specific underwriting standards; this has three implications:

1. It is quite possible that the arranger(s) of a non-local financing will not have sufficient credit capacity for the exposure on the loan and on the hedge.  If the total exposure is close to (or beyond) a certain underwriting threshold, the underwriter will require increasingly higher compensation – via a higher spread on the hedge – for the risk.

2. The hedge underwriter may have a fixed limit beyond which it cannot provide a hedge at any price, potentially leading the borrower to go unhedged or to purchase options (which need to be funded by equity and can be very expensive) on a portion of the debt.

3. The variation in credit charge modelling between banks is actually quite high. Although to an outsider it would probably seem unlikely to be the case, the all-in spread to market rates on a cross-currency swap from bank A may can easily be double that of bank B.

For any of these reasons, it may be incumbent on the borrower to arrange for a third party hedge provider to participate in the cross-currency hedging. This may be just to supplement the hedging capacity so that the full currency risk can be mitigated, but it could also be to establish a more reasonable spread for the all-in charges (credit plus execution) than that expected by the arranger(s) of the financing.

One of Chatham’s most important roles is to help each client with the analysis of the overall efficiency of different types of debt packages. Specifically, this is to take into consideration any costs or differentiating features associated with the hedging in as much detail as possible when the debt decision is being taken. Even though this holds true with all debt decisions, it is never more critical than with debt in foreign currencies due to the hedging sensitivity described above. Please contact us at the earliest possible stage when contemplating this type of debt package.

If we can assist you in any way…
Give us a call at +44 (0)20.7557.7000.

See Part 1