Hidden costs in foreign currency bond issuance

by Richard Class

A spotlight on the components of pricing

Many companies wish to diversify their funding sources, broaden their investor base, and possibly lower their funding costs by issuing bonds in foreign currencies. However, unless they have a direct requirement for funds in the currency of issuance, most borrowers will wish to swap the proceeds raised back into their base currency.

There are several types of market risk embedded in these cross-currency transactions which can make the overall pricing opaque. This article examines the structure of these transactions in detail and identifies ways to lower the overall costs of execution.

What market risks are involved?

Interest rate swaps

Bonds are usually issued paying a fixed coupon. The borrower may wish to pay either fixed or floating interest in its base currency. (Today, floating rates are usually based on an overnight index.). Hence, the overall package may involve either one or two interest rate swaps.

Cross currency basis swaps

A cross currency basis swap is essentially the exchange of a floating rate loan in one currency for a floating rate loan in another currency. There is an exchange of principal at both the start and end of the transaction at the same FX rate which is agreed at the beginning. During the life of the deal, regular floating interest payments are exchanged.

Let us consider a USD denominated company that wishes to issue a bond in EUR.  In theory, there should not be any spread between the SOFR and EONIA (the two overnight indices in USD and EUR respectively).

In practice, supply and demand for funding and global liquidity factors mean that there is often a spread. For example, in times of risk aversion in markets, investors would prefer to hold their liquidity in USD. This means they are prepared to lend their EUR at a negative spread under EONIA to obtain USD.

Conversion factors

Most companies must borrow money at a spread over the benchmark interest rate swap rate and the less well rated the company, the larger the spread required to compensate investors for the credit risk.

Suppose that our company can issue five-year bonds when swapped to floating rate at EONIA+ 50 bps and that the five-year basis swap price from EUR to USD is EONIA – 10bps versus SOFR flat. Does that mean that the cost of funding in USD is now SOFR + 60bps? NO! This is because the present value of 60bps paid quarterly in EUR for five years is worth more than 60bps paid quarterly in USD for five years because EUR rates are lower than USD rates.

The ratio that needs to be applied to make the two streams of income have the same value is known as the conversion factor. (Technically, it is the ratio of the sum of the discount factors in the two currencies.) Let us suppose that the conversion factor is EUR1:USD1.1. Hence the spread in USD is SOFR+66bps. Not all market participants are aware of this factor and even if they are, the bank could apply a spread that is to its advantage. This is particularly significant on deals with larger credit spreads.

Liquidity risk

A new issue swap tends to be done with just one institution and is not spread across multiple counterparties. This helps reduce news of the deal becoming market knowledge and means that only one market-making bank needs to pre-hedge.

However, cross currency basis swaps are illiquid, and the bank will probably want to pre-hedge to some degree in anticipation of executing the deal. Hence, pricing could move against the borrower, particularly when markets are less liquid and stressed.

Collateral management

Over the counter swaps are usually collateralised. The main market risk over time on the cross-currency swap will be the principal exchange at maturity. The mark to market over time could therefore be substantial. What are the terms of the collateral agreement? Will you have to post any initial margin? How frequently is the variation margin recalibrated and what instruments can you place as collateral, compared to what the bank may give to you? How are haircuts on collateral determined? All these issues may be ways in which the bank can earn additional income.

Understanding the cash flows – a worked example

Let us consider the following scenario and prices.

Company ABC issues a five-year fixed rate bond in EUR which can be swapped into floating at a rate of EONIA+50bps. The company wishes to have a fixed rate liability in USD.

Spot EUR/USD is 1.1. The five-year EUR/USD basis swap is trading at -10. (Basis swaps are usually quoted versus USD flat and interest is paid quarterly.) The five-year conversion factor is EUR1:USD1.1.  The five-year USD swap rate paid quarterly versus SOFR is 3.7%.

The next cost of funds for ABC in USD is thus 3.7% +66bps which is 4.36%, paid quarterly.

For completeness, the three components of the cross-currency swap are shown separately; the two interest rate swaps and the cross-currency basis swap, as each one is a discrete part of the overall transaction where the bank could charge a spread. In reality, one deal would be done – a fixed/fixed cross-currency swap.

Cross currency worked example

An Additional Consideration: Early Termination

Financial institutions and high yield companies can issue bonds which do not have a bullet maturity. For example, a bank may issue a subordinated bond which has a ten-year maturity, but it could be called by the issuer after five years. Although there is an expectation that the bonds will be called by the issuer, this is not guaranteed and depends on market conditions as the call date approaches. How does the issuer deal with this uncertainty?

There is the potential to trade cross currency swaptions, but this rarely happens. Instead, the swap package is terminated early and there is a mark to market on the principal exchange which is accelerated to be done now.

There are several factors to consider in the pricing of these elements. How close to mid-market is the swap terminated (especially for the spot price as the principal exchange will probably be for several hundred million)? Depending on whether the deal was in or out of the money, the bank will also factor the potential release of CVA on termination.

Conclusion

Cross currency swap packages for new issues are large, complex, and illiquid transactions, offering the bank multiple areas where they can charge additional spreads.

Your institution will execute these packages infrequently and your primary focus on the day will be on achieving your target cost of funds. Hence, you may not be fully aware of how all the components of the transaction have been priced.

We at OptimX can help you navigate these complexities and help you to achieve better terms, thereby lowering your funding costs.