Cash Management

Treasury Tips: Can There Be Too Much Debt?

Despite low yields and favorable bond market conditions, there are risks to consider when deciding whether to upsize that bond deal.
Ed ZwirnMay 30, 2001

Let’s say you’re the CFO of a firm in the middle of a major bond offering, and you find $20 billion of bids lined up for the $7 billion of bonds you pitched to investors on the “roadshow” last week.

Of course, you can hold the line on the size of the deal, and in the process lessen borrowing costs by keeping the securities in relatively scarce supply. But your fee-hungry investment advisors have been harping on you lately about how the yield you can obtain this time around would only have been lower about 1 percent of the time over the past 20 years.

And you’ve been itching to cut current debt costs and “term out” some of the existing commercial paper or other bank debt you have outstanding, or refinance outstanding bond issues, all of which are at higher-than-prevailing rates.

Not to mention future borrowing costs: With even middle class homeowners savvy enough to “lock in” low interest rates for as long as possible by refinancing into 30-year fixed-rate mortgages, why not do the same for your corporation’s debt?

So it’s a no-brainer: Take the “opportunistic” route and increase the size of your offering, paying a few basis points more than if you had limited its size, but in the process saving much more money in borrowing costs over the long haul.

Why It’s Not So Simple

Many financial executives of firms with relatively solid credit ratings have apparently made this call. Read your Bloomberg and you’ll note the many examples of bond issues that went seemingly out of control, driving the bond market to record issuance so far this year.

But the urge to max out those bond offerings and borrow as much as you can while you can do so cheaply involves strategic treasury/asset management considerations that are a great deal more complicated than the above scenario would indicate. Here are factors to consider before you decide to take the extra money and run:

  • Obviously, you need to be mindful of the need to match monetary flows. Does a finance company treasurer want to borrow huge amounts via 30-year fixed-rate paper when revenue streams come mainly in the form of loans maturing in no more than five years?
  • Also, consider whether or not you are undercutting your own borrowing program by being too opportunistic. Many issuers that formerly adhered to relatively rigid, quarterly bond issuance schedules have more recently created a bad name for themselves among investors by jumping into the market unexpectedly or with a larger deal than originally announced. The several basis points this may cost when it’s time to do the next bond offering may bring this point home.
  • Is “terming out” bank debt really such a safe bet? The financial world, as volatile as it has been over the past year, is awash with examples of firms that suffered reverses and then found themselves unable to reopen lines of credit they had earlier paid off in full.
  • And are you placing your chips on the right square when it comes to the direction interest rates may take in the future? Paying off bank debt using longer-term corporate bonds typically involves destroying a major hedge you have put in place by shifting your debt almost entirely into fixed-rate obligations. Of course, rates are currently low, but do you want to bet your career that they won’t go lower?

WorldCom Plays Coy

Take the case of WorldCom. The Clinton, Miss.-based telecommunications giant hit the record books in early May by concluding the largest bond offer by a U.S. firm.

In the several days leading up to pricing, the issuer–whose officials were unavailable for this article–raised the ante on the deal from an originally forecasted $7 billion-to-$8 billion, to a whopping $11.9 billion, or an apparent increase of as much as 70 percent.

But sources close to the deal at the time indicated it was sold at a wide spread relative to other telecom issuers in order to ensure that demand would exceed that amount. An outstanding comparable issue by rival Sprint was said to have been trading some 25 basis points more expensive than the new WorldCom offering.

“This is creating a feeding frenzy for the [WorldCom] paper,” said one of the sources the afternoon prior to the deal’s May 9 pricing.

And, however haphazard the final size of the deal may have appeared to outsiders at the time, industry analysts agree that the result neatly matched WorldCom’s actual funding needs, enabling the firm to pay off about $6 billion of commercial paper, refinance $3 billion of outstanding corporate bonds due between August and November, and take care of another $3 billion needed for working capital through year- end.

“From our perspective, they are fully funded for the remainder of 2001,” said William Densmore, who directs telecommunications analysis at Fitch.

“If they went to market and said they wanted $12 billion and came up with $7 billion to $8 billion, it would look bad,” he said. “It’s much easier to scale up than to scale down.”

Hedging the Bet

But as the WorldCom deal also illustrates, other concerns may take center stage when a firm succeeds in remaking its debt profile.

While the record bond offering helped WorldCom greatly decrease its cost of funding, the resultant replacement of virtually all of the firm’s shorter, floating paper generated the need to diversify in order to maintain the firm’s normal debt profile.

Just taking the announced portions of the corporate bond deal into account, the new WorldCom debt mix would contain “very little floating- rate debt,” says Dave Novosel, managing director at Bank One Capital Markets, adding that the firm normally would maintain about 25 percent of its debt in variable-rate paper.

“A lot of [recently refinancing] firms would like to have floating- rate debt in case rates go lower,” he says.

And WorldCom may have already rectified this imbalance by swapping much of the $11.9 billion of fixed-rate debt into floating as part of its recent bond deal.

The three U.S. dollar segments of the deal consisted of $1.5 billion of 6.5 percent three-year notes, which priced at 99.823 percent of face value to yield 6.566 percent, or 215 basis points over Treasurys; $4 billion of 7.5 percent 10-year paper at 98.904 to yield 7.659 percent, or 245 basis points over; and $4.6 billion of 8.28 percent 30-year bonds at 98.098 to yield 8.425 percent, or 265 basis points over.

A source close to the swap market indicates that “a large chunk of the 30-year [tranche] was swapped,” as well as about half of the 10- year.

In the case of the 30-year segment, the prevailing swap rate in effect at that point would have been approximately 200 basis points over the London Interbank Offered Rate (Libor), or about 6 percent. For the issuer, the swap will continue to accrue positive value to the income statement under GAAP, provided the variable rate does not exceed 8.28 percent (the coupon) over the life of the 30-year bond.

Ford: Too Much of a Good Thing?

Another issuer which greatly increased the size of a prominent bond deal this year was Ford Motor Credit Corp., the finance arm of the auto giant.

FMCC, which as a finance company with varying cash flows is known in market circles to swap most of its longer-term fixed-rate debt into floating, issued more than $8.2 billion (some 65 percent over the original announcement) of five- and 10-year dollar-denominated and three-year euro debt on Jan. 25.

But the issuer, which in 1999 attempted to unveil its GlobLS (Global Landmark Securities) program, under which the $8.2 billion was priced, as an alternative to Fannie Mae Benchmark Notes, has been hurt in the eyes of investors looking for supply certainty by its perceived willingness to come into the market whenever conditions are conducive.

“Ford walks a thin line between providing customers with what they want and providing the market with too much,” says Kevin Morley, managing director in the fixed-income division of Credit Suisse First Boston.

Fazal Merchant, who as the Ford Motor Co.’s manager of North American and European funding is responsible for all parent company and subsidiary borrowing, admits to walking the line.

“There are several strategic issues and numerous variables that come into consideration,” he says. “You want to come out with a size that seems realistic and then build some momentum.”

“It’s not like we always do a billion dollar deal and announce a $500 million deal,” says Merchant. “But you have to take care of investors that you have a relationship with. You don’t want to have to go back and allocate $1 million on a $100 million order.”

“It’s every bit as much an art as a science,” he adds.

Citizens Reinvents Itself

Don Armour, Citizens Communications vice president of finance and treasurer, came to his present job by way of the treasurer’s office of Time-Warner Cable.

Although Stamford, Conn.-based Citizens has a corporate history going back to 1935, it began shifting its focus from utilities to telecommunications via acquisitions and divestitures in the 90s.

This process reached fruition in May 2000, when the firm officially changed its name from Citizens Utilities.

One year later, the renamed company was in the market peddling $1 billion of Baa2/BBB five- and 10-year bonds, in a deal that was quickly increased to $1.75 billion by the time it priced May 18.

“This deal was like our re-IPO,” says Armour, noting that it is the first public securities offering that the firm has conducted since it changed its name. The firm, under its old name, had been last seen in the bond market with a “series of issues, none over $200 million, between 1994 and 1996.

“For me, the whole thing here was to completely remake a company,” he says, noting that Citizens’ debt profile was “a mixed bag with not a lot of cohesion” prior to his taking the finance helm. The “just over $2 billion” of overall debt at that point consisted of not only bonds and bank credit, but also government loans and leases.

“We could have taken out more debt, but we wanted to stop,” he says. “We traded up after closing, and our purchasers walked away happy.”

And Armour says, having accomplished the nearly complete overhaul of the company’s debt, he will probably turn toward equity for balance as he uses up the remainder of the $3 billion shelf filed earlier this year.

But as far as fine-tuning the debt itself to hedge between floating- rate and fixed, that is a non-issue, he says.

“We’re an operating company so what we want to do is fix rates,” he says. “We’re not here to play the interest-rate game.”