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6.6 Hedging a forecasted issuance of debt
Publication date: 31 Mar 2024
us Derivatives & hedging guide
To economically fix the interest payments on debt, reporting entities may engage in hedging activities related to a forecasted issuance of debt. For hedging strategies involving the forecasted issuance of debt, support for the assertion that the forecasted issuance is probable of occurring is necessary to designate the interest payments as hedged items. The designated hedging instrument in this type of hedge strategy is typically an interest rate swaption or a forward starting interest rate swap.
Regardless of whether the forecasted debt issuance being hedged is expected to have a fixed or variable interest rate, the hedging relationship will fall under the forecasted transaction cash flow hedging model.
6.6.1 Hedging a forecasted issuance of fixed-rate debt
For the forecasted issuance of a fixed-rate financial instrument, the hedge accounting model is much different from that applied for an existing fixed-rate financial instrument. Hedging the interest rate risk in an existing fixed-rate financial instrument is considered a fair value hedge, while hedging the interest rate risk in the forecasted issuance of a fixed-rate financial instrument is considered a cash flow hedge.
Hedge accounting is generally terminated at the debt issuance date because the reporting entity will no longer be exposed to cash flow variability subsequent to issuance. Accumulated amounts recorded in AOCI at that date are then released to earnings in future periods to reflect the difference in (1) the fixed rates economically locked in at the inception of the hedge and (2) the actual fixed rates established in the debt instrument at issuance. Because of the effects of the time value of money, the actual interest expense reported in earnings will not equal the effective yield locked in at hedge inception multiplied by the par value. Similarly, this hedging strategy does not actually fix the interest payments associated with the forecasted debt issuance.
Fixing the interest payments associated with debt may be achieved by committing to issue debt in the future at a specific fixed interest rate and then hedging the net proceeds from the issuance of the debt. In such a hedge, the proceeds or payments resulting from the termination of the hedging instrument will offset the cash discount or premium received from the lender at debt issuance. In future periods, the amortization of the premium or discount on the debt will be offset by the release of a corresponding amount from AOCI.
The hedged risk can be designated as the risk of changes in either (1) the coupon payments (or the interest element of the final cash flow if interest is paid only at maturity) related to the forecasted issuance of fixed-rate debt or (2) the total proceeds attributable to changes in the benchmark interest rate related to the forecasted issuance of fixed-rate debt.
Question DH 6-15
DH Corp expects to issue at par ten-year fixed-rate debt in 6 months on June 15, 20X1, and management has determined that the future issuance of debt is probable and that it is probable that there will be ten years of interest payments.
DH Corp wants to hedge the changes in the benchmark interest rate from January 15, 20X1 to June 15, 20X1 that will impact the debt’s fixed interest rate. DH Corp executes a Treasury rate lock on January 15, 20X1.
Can DH Corp designate the Treasury lock to hedge the risk of changes in the cash flows due to the changes in the benchmark interest rate of the ten years of interest payments resulting from the forecasted debt issuance?
DH Corp expects to issue at par ten-year fixed-rate debt in 6 months on June 15, 20X1, and management has determined that the future issuance of debt is probable and that it is probable that there will be ten years of interest payments.
DH Corp wants to hedge the changes in the benchmark interest rate from January 15, 20X1 to June 15, 20X1 that will impact the debt’s fixed interest rate. DH Corp executes a Treasury rate lock on January 15, 20X1.
Can DH Corp designate the Treasury lock to hedge the risk of changes in the cash flows due to the changes in the benchmark interest rate of the ten years of interest payments resulting from the forecasted debt issuance?
PwC response
Yes, assuming the hedging relationship meets all of the appropriate requirements of ASC 815, DH Corp can hedge the benchmark interest rate in a forecasted issuance of fixed-rate debt.
A Treasury rate lock agreement is a financial instrument that allows a reporting entity to “lock in” the current benchmark interest rate applicable to US Treasury securities and results in a net cash payment at the settlement of the agreement based on the difference between the current benchmark Treasury yield and the rate that was locked-in via the Treasury rate lock. Because a Treasury lock locks in the current benchmark Treasury rate, it acts as a natural economic hedge for the portion of the variability on the future interest payments of a forecasted fixed-rate debt issuance due to the benchmark interest rate risk because the debt’s fixed rate will not be determined until the pricing date of the debt issuance and will be based on then-current market interest rates.
If DH Corp uses a Treasury lock as the hedging instrument, due to the nature of how it is valued and settled, the Treasury rate lock generally will not be a perfectly effective hedging instrument.
The valuation and settlement of a Treasury lock will be based on the then-current yield on the most recently issued on-the-run Treasury security for a particular maturity (e.g., at its maturity, the settlement of a ten-year Treasury rate lock will be based on the yield of the most recently issued ten-year Treasury security). As a result, once a new Treasury security for the relevant maturity has been issued, the Treasury lock will be priced based on this new security. Normally, securities underlying the Treasury lock (i.e., the current or any future Treasury issuance of the appropriate maturity) will not have cash flows that match those of the forecasted debt issuance exactly. For example, assume a Treasury lock was executed on January 15 with a maturity date of June 15 to hedge ten years of semi-annual interest payments to occur each December 15 and June 15. Further assume that the relevant on-the-run ten-year Treasury security had semi-annual interest payment dates of November 15 and May 15. As a result, the yield on the underlying Treasury security (which, again, is the basis for the settlement of the Treasury rate lock) will be calculated based on a different set of cash flows than the cash flows on the debt being hedged.
The Treasury lock is not likely to be a perfectly effective hedging instrument because even at hedge inception, it is highly unlikely that the timing of the interest payments relating to the Treasury security underlying the Treasury lock will exactly match the timing of the interest payments relating to the forecasted debt issuance. In addition, subsequent issuances of Treasury securities may result in more mismatch in the relationship and if a quantitative assessment of effectiveness is used, will result in more complex calculations.
Example DH 6-4 illustrates use of a swaption to hedge the forecasted issuance of fixed-rate debt.
EXAMPLE DH 6-4
Use of a swaption to hedge a forecasted issuance of debt
Use of a swaption to hedge a forecasted issuance of debt
On January 1, 20X1, DH Corp anticipates that on January 1, 20X2, it will issue $10 million of two-year, fixed-rate debt with the coupon set at the market interest rate at that date. Interest will be paid annually on December 31 each year.
To protect itself from an increase in the benchmark interest rate for the two-year forward period of January 1, 20X2 to December 31, 20X3, during the one-year period from January 1, 20X1 to January 1, 20X2 DH Corp purchases, for a premium of $20,000, an option that gives it the right, but not the obligation, to enter into a two-year, receive-variable (one-year SOFR), pay-fixed (8%) interest-rate swap (a swaption) as of January 1, 20X2, based on a notional amount of $10 million. Fixed interest payments on the swap would be made on an annual basis on December 31 if the option to enter the swap is exercised by DH Corp.
The interest rate curve is flat. The SOFR swap rate is 8% on January 1, 20X1 and 10% on December 31, 20X1. The interest rate change from 8% to 10% occurred on the last day of the year (December 31, 20X1).
DH Corp designates the swaption as a cash flow hedge of changes in the forecasted interest payments due to benchmark interest rate risk related to the forecasted issuance of fixed-rate debt. DH Corp assesses hedge effectiveness based on changes in the option’s intrinsic value and elects to recognize the excluded component (i.e., time value) using an amortization approach. Per the guidance in ASC 815-20-25-83A, DH Corp recognizes the amortization of the initial value of the excluded component in earnings over the life of the hedging instrument. DH Corp elected to amortize the excluded component on a straight-line basis, but other methods could be acceptable.
The swaption’s fair value increased in value to $50,000, to $230,000, and to $300,000 at each of the first three respective quarter-ends during 20X1. On January 1, 20X2, the swaption is settled with the original counterparty at a fair value of $347,107. The swaption is terminated at the debt issuance date, January 1, 20X2, since DH Corp will no longer be exposed to interest rate variability after the pricing date of the fixed-rate debt issuance.
How should DH Corp account for the hedging relationship?
Analysis
Upon documenting the hedge and performing effectiveness testing, DH Corp is able to assert that the hedge is expected to be highly effective in offsetting changes in the designated hedged risk. The swaption contract would be recorded on the balance sheet at fair value as an asset or liability. As an effective cash flow hedge, the swaption’s gain or loss would be deferred through OCI until the hedged transactions, the forecasted interest payments, impact earnings. When the forecasted interest payments impact earnings, the swaption’s gain or loss would be reclassified from AOCI to the same income statement line item as the hedged item.
The journal entries to record the hedging relationship are as follows. The figures are calculated based on the effective yield method of releasing AOCI using the debt’s effective rate of 8.10352% (similar to amortization of a premium of $347,107). Other methods of releasing AOCI to earnings may also be acceptable.
DH Corp would record the following journal entries.
January 1, 20X1
Dr. Swaption contract
|
$20,000
|
|
Cr. Cash
|
$20,000
|
|
To record the purchase of the swaption
|
||
March 31, 20X1
Dr. Swaption contract
|
$30,000
|
|
Cr. Other comprehensive income
|
$30,000
|
|
To record the change in the fair value of the swaption
|
||
Dr. Interest expense
|
$5,000
|
|
Cr. Other comprehensive income
|
$5,000
|
|
To record the amortization of the initial time value of the swaption
|
||
June 30, 20X1
Dr. Swaption contract
|
$180,000
|
|
Cr. Other comprehensive income
|
$180,000
|
|
To record the change in the fair value of the swaption
|
||
Dr. Interest expense
|
$5,000
|
|
Cr. Other comprehensive income
|
$5,000
|
|
To record the amortization of the initial time value of the swaption
|
||
September 31, 20X1
Dr. Swaption contract
|
$70,000
|
|
Cr. Other comprehensive income
|
$70,000
|
|
To record the change in the fair value of the swaption
|
||
Dr. Interest expense
|
$5,000
|
|
Cr. Other comprehensive income
|
$5,000
|
|
To record the amortization of the initial time value of the swaption
|
||
December 31, 20X1
Dr. Swaption contract
|
$47,107
|
|
Cr. Other comprehensive income
|
$47,107
|
|
To record the change in the fair value of the swaption
|
||
Dr. Interest expense
|
$5,000
|
|
Cr. Other comprehensive income
|
$5,000
|
|
To record the amortization of the initial time value of the swaption
|
||
January 1, 20X2
Dr. Cash
|
$347,107
|
|
Cr. Swaption contract
|
$347,107
|
|
To record the settlement of the swaption
|
||
Dr. Cash
|
$10,000,000
|
|
Cr. Debt
|
$10,000,000
|
|
To record the issuance of the fixed-rate debt
|
||
For simplicity and to more easily illustrate the concepts of the release of amounts accumulated in other comprehensive income, annual journal entries are shown subsequent to the debt offering (quarterly entries would be required).
December 31, 20X2
Dr. Interest expense
|
$1,000,000
|
|
Cr. Cash
|
$1,000,000
|
|
To record the interest payment on the debt
|
||
Dr. Accumulated other comprehensive income
|
$166,836
|
|
Cr. Interest expense
|
$166,836
|
|
To amortize a portion of the gain on the swaption as an adjustment of the interest expense on the debt.
|
||
December 31, 20X3
Dr. Interest expense
|
$1,000,000
|
|
Cr. Cash
|
$1,000,000
|
|
To record the interest payment on the debt
|
||
Dr. Accumulated other comprehensive income
|
$180,271
|
|
Cr. Interest expense
|
$180,271
|
|
To amortize a portion of the gain on the swaption as an adjustment of the interest expense on the debt
|
||
Dr. Debt
|
$10,000,000
|
|
Cr. Cash
|
$10,000,000
|
|
To record the repayment of the fixed-rate debt
|
||
6.6.2 Hedge of forecasted interest payments on variable-rate debt
For the forecasted issuance of a floating-rate debt instrument, the hedged item is typically designated as forecasted interest payments, and the hedged risk is the contractually specified interest rate expected to be in the variable-rate debt. This is the same manner in which the hedged item and hedged risk are designated when hedging an existing variable-rate financial instrument. Thus, the cash flow hedging model for hedging variable interest payments/receipts is similar for both existing financial instruments and forecasted issuances of financial instruments.
When hedging the future variable-rate interest payments associated with a forecasted issuance of debt, the hedging instrument (e.g., a forward starting interest rate swap) could technically remain outstanding until the maturity of the debt instrument.
However, it is not uncommon to terminate the existing swap and enter into a new swap that exactly matches the debt issued to facilitate cash flow hedging under a qualitative assessment method. The amounts in AOCI for the terminated hedge associated with the forecasted issuance of the variable-rate financial instrument will be reclassified into earnings in a manner that reflects the economically fixed yield established at inception of the hedge.
6.6.2.1 Using a swaption to hedge forecasted interest payments
Consistent with Example DH 6-4 related to hedging fixed-rate debt issuances, a reporting entity could designate a swaption (that is, an option to enter into a predefined swap) as a cash flow hedge of the variability in the contractually specified interest rate index payments in the forecasted debt instrument in excess of a specified strike price defined in the swaption. The reporting entity may designate only changes in the intrinsic value of the contractually specified interest rate index in interest payments as the risk being hedged. Assuming the swaption had no intrinsic value at inception, and the entity elected to amortize the excluded component, the premium paid for the swaption would be amortized to interest expense over the life of the swaption from the date the swaption is transacted through the debt issuance date. Note that this “cost of hedging” is recorded as interest expense prior to the debt being recognized on the books of the reporting entity. The intrinsic value of the swaption hedge deferred in AOCI (if any) would be amortized to interest expense as the hedged interest payments occur after the debt issuance. If the swaption is exercised and the reporting entity accepts the swap contract underlying the swaption as settlement and the reporting entity wants to apply hedge accounting to the swap contract, this new instrument would have to be separately designated in a new hedge relationship of the future variability in the interest payments on the debt. Since the swap received as settlement for the swaption does not have a fair value of zero (its pay-leg is lower than that of an at-the-market instrument), at a minimum, an initial quantitative test to demonstrate high effectiveness would be required.
6.6.3 Hedge of forecasted interest when the coupon rate is unknown
If the reporting entity does not know whether it will issue fixed- or variable-rate debt, it would designate the hedged risk as the variability in cash flows attributable to changes in a rate that would qualify as both a benchmark rate and a contractually specified rate.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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