Over recent months, corporate treasurers have needed to manage the effects of an unpleasant blend of macro-economic woes, including inflation at multi-decade highs, deterioration of economic outlooks and persistent geopolitical risks.
Central banks have used increased rates to combat inflation, with further volatility entering the currency markets from the lack of co-ordination of the timing of those rates rises.
The focus of this briefing is on how corporate treasurers are using derivatives to manage the risks associated with higher rates and increased market volatility and the related legal considerations.
Companies are increasingly using pre-hedging transactions to protect the economic viability of anticipated future financings. Pre-hedging transactions give rise to specific legal considerations for companies which do not arise in more traditional hedging arrangements.
Examples of pre-hedging transactions include forward-starting interest rate swaps and swaptions.
FORWARD STARTING INTEREST RATE SWAPS
Under a forward-starting interest rate swap, parties can agree that fixed/floating payments will commence on a future date that coincides with an anticipated financing.
The terms of a forward-starting interest rate swap often provide for its mandatory termination prior to any requirement to make fixed/floating payments. Following mandatory termination, one party pays to the other a cash settlement amount representing the value of the underlying swap transaction as of the specified mandatory termination date.
Mandatory termination avoids a circumstance where the company is required to make future fixed/floating payments under the swap even if the financing has not proceeded as planned. If, however, the financing has proceeded and rates have moved against the company (increasing the value of the underlying swap), then the company will receive a cash settlement amount which can be offset against the costs of any new hedging transactions entered into following completion.
A swaption is an option to enter into a swap. Under a swaption, a company can pay its bank counterparty a premium in exchange for the option to enter into a swap on a future date.
A company can use a swaption in order to ensure that interest rate movements between its purchase of the option and an anticipated future financing do not result in increased funding costs. The swaption will only be exercised if rates have increased to the detriment of the company's proposed financing. If interest rates reduce (reducing the funding costs of the financing) the company would not exercise its option and its only loss would be limited to the amount of its premium.
KEY LEGAL CONSIDERATIONS
Companies will need to consider whether any pre-hedging that it has entered into is permitted by the terms of the eventual financing if the hedging will remain in place after completion.
The terms of the pre-hedging themselves are generally set out in a transaction confirmation incorporating definitions published by the International Swaps and Derivatives Association, Inc. (ISDA)©. Although standardised, companies will need to understand the terms properly and the effect of different elections which can determine various commercial matters including exercise, settlement and payments.
LIQUIDATING/RESTRUCTURING IN-THE-MONEY TRANSACTIONS
Transactions entered into by companies prior to the recent transition into a higher interest rate environment may now have a positive value ('in-the-money'). Corporate treasurers could partially or fully liquidate in-the-money transactions in their derivatives portfolio to generate cash.
Corporate treasurers could also consider other ways of extracting value, such as amending transaction profiles to reflect changes to the company's business plan since trading or extending any mandatory breaks.
KEY LEGAL CONSIDERATIONS
Companies will need to ensure that any liquidation/restructuring of its transactions is permitted by the terms of any underlying facility documentation. Companies will also need to ensure that changes to existing transactions are properly documented.
CHANGES TO PRODUCT SELECTION
Higher interest rates have resulted in increases to the premiums payable by companies in respect of interest rate caps (counterparty banks are more likely to be required to make higher and frequent payments under those transactions).
The higher premiums for interest rate caps may result in companies opting instead for alternative products, such as interest rates swaps.
KEY LEGAL CONSIDERATIONS
Given the reduced credit risk of an interest rate cap from the perspective of a bank counterparty (as the company has often made all of its payments to the bank counterparty on the purchase date), caps are often documented under a long-form confirmation (LFC). An LFC is typically a short document.
As a bank counterparty can have a credit exposure to a company under other products, including an interest rate swap, bank counterparties will spend more time tailoring the legal documentation and will generally insist that they are documented under a full form ISDA Master Agreement.
Although an LFC typically incorporates the terms of a standard form ISDA Master Agreement by reference, there tends to be limited scope for negotiation of the legal and credit terms. Where the parties execute a full form ISDA Master Agreement, given that it is a longer-form document, there is generally greater scope for negotiation to reflect the particular legal and credit concerns of each of the parties. Companies will need to be prepared for the associated time and costs of the additional documentation.