Accessing the offshore market and important hedging considerations

Executives from Chatham Financial (Chatham) in Australia look at some of the hedging and ongoing accounting issues arising for a typical corporate borrower when accessing offshore capital markets.

CHATHAM FINANCIAL PARTICIPANTS
  • Andrew Brown Head, Australia and New Zealand
  • Ron Ross Head of Business Development
  • Juan Enrique Arreola Director, Accounting Advisory Services

While many corporates understand the key value propositions offered by offshore markets – among them increased liquidity, depth and tenor – accessing these also involves a likely need for cross-currency hedges.

Australia and New Zealand provide relatively liquid derivatives markets to bring offshore issuance back to local currencies, and bank hedge pricing remains highly competitive towards the end of a long expansionary cycle.

However, the range of bank prices is increasing, particularly when considering the range of offshore markets – including euros, yen and US dollars – have quite different hedge cost to bring back to Australian or New Zealand dollars. Chatham hedges slightly more than US$2 billion globally for its clients daily and spread volatility is readily apparent.

Why is cross-currency hedging especially important for Australasian corporate borrowers?

ROSS Australian and New Zealand corporates have tended to average some A$30-40 billion (US$21.9-29.2 billion) aggregate of annual bond issuance since the financial crisis, going back at least to 2010 or 2011. In excess of half this total, and often closer to two-thirds, is sourced from offshore bond markets.

This is all well documented and is primarily US private placements (USPPs) – particularly for unrated issuers, regulated utilities and first-time issuers. The US 144A market is usually the domain of more recognised borrowers seeking to raise larger volume while the recent emergence of Asian liquidity has seen a greater number of Reg S issuers successfully come to market.

Add in a small number of euro transactions and a handful of Asian local currency deals, in Hong Kong dollars, Singapore dollars or yen, and these avenues combined far outweigh what is achieved in the local bond market. For many years the local option lacked any real depth or execution certainty for triple-B rated issuers and it is still often challenged when it comes to 10-year tenor.

It is for a variety of reasons, therefore, that corporates will look to offshore markets. The conventional reasoning includes factors such as execution certainty, the fact that USPP deals do not require a formal credit rating, the greater volume able to be achieved, the fact that longer tenor is more readily available, and investor diversification.

What is the state of play in the derivatives space?

BROWN Recent developments in the derivative markets, which need to be considered as part of any issuance, include changes to the calculation of bank-bill swap rate (BBSW) in Australia and to underlying secured markets.

This has driven a widening of BBSW relative to the Reserve Bank of Australia cash rate, with commensurate increased borrowing costs for issuers swapping back to Australian dollars.

ROSS Additionally, international derivatives regulatory changes highlight the fact that banks globally have different capital and regulatory charges. Chatham works with regulators on behalf of many end users to simplify the regulatory burden on companies.

To add to the complexity, views on the potential likelihood of future regulatory changes are affecting pricing for longer-dated hedges today, such as those contemplated when accessing offshore markets. 

We have seen an increased propensity for corporate borrowers to print Australian dollar tranches in USPP deals. Does this get round the challenges inherent in long-dated cross-currency swaps?

“Overwhelmingly, we hear corporates point out the accounting for ‘cross-currency basis’ or simply ‘currency basis’ as one of the primary pain points of transitioning to AASB 9.”

ANDREW BROWN

We have seen an increased propensity for corporate borrowers to print Australian dollar tranches in USPP deals. Does this get round the challenges inherent in long-dated cross-currency swaps?

BROWN In some respects, yes, the accounting challenges we discuss subsequently disappear. However, there are some benefits and costs economically. The benefits include removing the need for a cross-currency hedge, which ties up bank credit capacity and adds complexity.

Often, though, the cost is not fully examined. Australian dollar notes bring with them implicit hedges. As long as debt is held to the absolute maturity date, no ‘implicit’ swap is invoked. But sometimes debt is actually refinanced early – sometimes as soon as 1-2 years after issuance, through to at latest generally 12 months prior to maturity – to avoid debt becoming fully ‘current’.

In this scenario, the note agreement refers to underlying derivatives but the borrower has no visibility around the terms of this hedge or the way any unwind costs are calculated. This exposes the borrower to potentially significant break costs at the refinancing time. In the scenario of taking outright hedges, a commercial discussion can at least be held with the bank as the counterparty to the transaction.

With the issuance of AASB 9 financial instruments, what are the new accounting challenges when considering hedging offshore debt issuance via cross-currency swaps?

ARREOLA Cross-currency swaps can exhibit substantial volatility in their fair value as a result of changes in spot FX rates and the interest-rate differential of the relevant currencies during their term. The benefits of applying hedge accounting to minimise potential P&L volatility has long been well understood by corporates under the previous accounting standard, AASB 139.

Corporates with a knowledge of applying hedge accounting to cross-currency swaps under AASB 139 might presume existing tools and approaches will also suffice when moving to the replacement standard, AASB 9. However, subtle yet very important changes have been introduced under the new hedge-accounting model, which means most companies will now need a more granular and sophisticated approach both to valuing cross-currency swaps and to modelling the hedge ineffectiveness and P&L impacts.

BROWN Overwhelmingly, corporates point out the accounting for “cross-currency basis” or simply “currency basis” as one of the primary pain points of transitioning to AASB 9. Additionally, currency basis can also be a significant yet less well-known driver of fair value volatility in cross-currency swaps.

What is currency basis, and how does its accounting treatment differ between the old AASB 139 and the replacement standard of AASB 9?

ARREOLA To keep things high level, currency basis is a premium or discount charged by market participants for funding in one currency relative to another over a period of time. Said another way, currency basis reflects market supply-and-demand forces beyond current spot and the interest-rate differential, as it demonstrates the preference of investors to pay or receive a particular currency against another over a given tenor.

Legacy hedge accounting under AASB 139 did not require hedgers to quantify and account for currency basis separately. However, AASB 9 introduces new accounting requirements for currency basis, which involve the ability to quantify and track it on an ongoing basis.

Depending on facts and circumstances, and specific accounting elections made by management during the hedge-accounting designation process, the impact on financial statements on cross-currency swaps due to currency basis can vary quite significantly. All options should be carefully considered.

About Chatham Financial

Chatham Financial (Chatham) is an independent financial risk-management firm helping clients overcome common yet complex capital-markets challenges. Chatham works with more than 2,000 clients globally, providing advisory and technology solutions to corporations, financial institutions, and private-equity and real-estate companies.

Since its foundation, in 1991, Chatham has hedged more than US$5 trillion of notional value. In doing so, it has helped clients understand and use debt and derivatives as a critical piece of their financial strategies. Chatham is a multiple bottom-line firm committed to delivering trust and transparency in the capital markets.

 

Interviewee bios

Andrew Brown established Chatham’s Australian operations, in 2013. Prior to joining Chatham, Andrew led the derivatives businesses at UBS Australia and at RBS Europe-wide. Additionally, Andrew worked at Barclays Capital, leading the event-driven business since 2001.

Ron Ross was previously an executive director at ANZ, where for six years he was head of debt capital markets. Prior to this, Ron was a managing director at Merrill Lynch, working for 18 years in Sydney and London. Ron has also been a managing director at BNP Paribas, where he was based in Hong Kong as head of debt capital markets for the Asia-Pacific region.

Juan Enrique Arreola serves as Chatham’s IFRS hedge-acccounting leader for Australasia, Asia, North America and Latin America. Prior to joining Chatham, Juan worked at Ernst & Young, leading technical transaction-accounting projects. He also worked at Morgan Stanley, focused on a private-equity fund with capital in excess of US$8 billion.

Why did AASB 9 introduce such a significant update?

ARREOLA One of the primary goals of the new standard was to create better alignment between the economic nature of hedging and the accounting results. When it comes to designating a cross-currency swap – or any other derivative – in a cash-flow hedging relationship, the company needs to be able to model the exposure being hedged in order to perform effectiveness assessments and thereby measure ineffectiveness.

AASB 9 cites currency basis as an example of a component that is only present in the cross-currency swap – a dual-currency instrument – but not in the hedged item, which is a single-currency instrument.
Modelling the exposure being hedged is often achieved by modelling a hypothetical derivative that perfectly matches the critical economic terms – for instance principal, term and payment dates – of the hedged item, which perfectly offsets the hedged risk.

AASB 9 makes it clear that the hypothetical derivative cannot include features that exist in the hedging instrument but not in the hedged item. Thus the hypothetical derivative cannot include currency basis because it is not a component of the hedged item.

Fortunately, AASB 9 also provides some relief in how to account for the currency basis, which is essentially an unavoidable cost of the hedging instrument. AASB 9 allows the currency basis piece of the cross-currency swap to be bifurcated from the hedge-accounting designation of the hedging instrument and accounted for in one of two ways.

First, a company can elect to have the changes in fair value of the currency basis flow directly through P&L. Alternatively, it can apply the newly-introduced “cost-of-hedging” approach.

Under this approach, the bifurcated inception-date currency basis would be recognised through P&L at the same time as the hedged item – which, depending on the nature of the hedged item, could be determined to be transaction related or time-period related.

When the cross-currency swap is used to hedge currency or interest-rate risk on foreign issuance, the protection against the hedged risk is considered to be over a period of time – and hence time-period related. The cost-of-hedging approach is proving to be a successful way for Chatham’s clients to designate this type of cross-currency swaps, resulting in a predictable and nonvolatile recognition pattern for currency basis.

How would you summarise the key considerations of AASB 9 as it pertains to cross-currency swaps?

ARREOLA There is no doubt that AASB 9 simplifies the application of many aspects of hedge accounting. However, cross-currency swaps, and FX contracts in general, fall into the category in which the new standard introduces some new challenges and considerations.

One major driver of these challenges centres on currency basis and on companies’ abilities to quantify and recognise hedge ineffectiveness, since this component of the hedging instrument can no longer be included in the hypothetical derivative under cash-flow hedge accounting.

BROWN The cost-of-hedging approach provides a good path forward for companies but this approach also comes with additional modelling complexities. Companies should be careful not to underestimate the complexities surrounding this critical area of the new standard.

Being able to model and bifurcate currency basis both at inception of the hedging relationship and on an ongoing basis can be quite complicated and, if performed incorrectly, can lead to painful and expensive cleanup projects*. 

* Please see Chatham’s white paper discussing quantifying currency basis and applying hedge accounting for cross-currency swaps under AASB 9 in detail at https://resources.chathamfinancial. com/hedge-accounting/chatham-quantifying-currency-basis-and-applying-hedge-accounting-for-cross-currency-swaps-under-ifrs-9.