One of the most frustrating decisions CFOs currently face is what to do with pay-fixed swaps after the underlying variable rate bonds are refunded and the swaps are no longer needed, aka “orphaned”.
Pay-fixed swaps are usually put in place to synthetically achieve a lower cost of debt than with conventional fixed rate bonds, by issuing variable rate “put” bonds and swapping their coupon to fixed rate. The put bonds require credit enhancement, and bank LOCs are in very short supply as of lately. It’s estimated that $15 billion of healthcare LOCs will come up for renewal in 2011, more than 3 times the 2010 levels. As banks continue to make LOC renewals prohibitively expensive and the interest rate environment remains at historical lows, healthcare borrowers will be looking to take out more variable rate bonds, leading to more orphaned swaps.
Most swap agreements give the borrower an early termination option, which will eliminate the cost of carrying the orphaned swap. A typical pay-fixed swap has a borrower paying a fixed rate of around 3-4%, and receiving 67% of the 1- or 3-month Libor. The exact percentages depend on market conditions at the time the swap was executed. Since Libor is worth close to nothing right now due to the very low short term rate environment, the net payment or “cost of carry” of an orphaned swap is effectively the fixed rate.
Termination may do away with the cost of carry, but can be expensive if the swap’s mark-to-market is negative. Mark-to-market is the value of the swap based on the present value of expected future net cash flows, using the implied Libor yield curve to project the variable rate leg. If the borrower is expected to make net payments to the counterparty, the swap’s mark-to-market will be negative, and because a swap can go out many years, a termination payment can easily reach into the millions of dollars.
So the basic choices are to either terminate by writing a big check now, or to carry the swap and write a smaller check each year betting that rates will rise and the swap can be terminated later for less. We’ll ignore swap restructuring options offered by some investment banks, because we have yet to see a proposal that does not trade savings for additional risk.
The decision to carry vs. terminate can be supported by a breakeven analysis with some assumptions about the magnitude and pace of interest rate changes. The swap’s cost of carry itself is a moving target because a rise in short term rates will increase the receive leg payment. The analysis is more straightforward with a specific outlook on interest rates: if a borrower expects rates to rise and do so relatively quickly over time, the analysis may favor carrying the swap. If on the other hand rates are not expected to rise, terminating may be the better option.
Some boards have grown more risk averse in recent past and may favor termination since it creates certainty by eliminating interest rate risk. There are also other factors to consider, including the impact on days cash on hand if the termination payment is funded out of pocket. In some situations the swap can be recycled to hedge remaining variable rate bonds.
The good news is rating agencies won’t generally penalize a borrower for carrying orphan swaps, so long as management has a swap policy in place and a termination strategy. An independent third party retained to advise management on swaps will also be viewed by agencies as a positive.
The analysis on what to do with orphaned swaps can be complex, but is worth going through given the significant dollars involved and the potential impact on liquidity.