Should corporates manufacture inflation hedges?

Reuters’ Breakingviews has a column suggesting that a number of corporates are issuing floating rate debt in order to service the demand of investors for an inflation hedge. Recent issuers mentioned are Berkshire Hathaway, General Electric and MetLife. The column is entirely conjectural on whether this is the actual motivation of these companies. And the column makes much of a tiny sample  and short window. But…

There is very good evidence that companies are more likely to choose a floating rate issue over fixed when the yield curve is steep as it is today and has been for a while. The recent literature began with a paper by Michael Faulkender (now at UMaryland) in the Journal of Finance. There has been a long stream following that. Faulkender studied issuance by companies in the chemical industry and found:
(i) their exposure to interest rates did not predict their choice of floating vs. fixed interest rate debt — i.e., hedging needs did not drive the choice, and
(ii) the price of interest rate risk did not predict their choice –i.e., they were not selling the highest value security.
Instead, the companies appeared to be choosing floating vs. fixed in order to:
(a) manage earnings, or
(b) ride the yield curve, a familiar and dubious speculative strategy.

The Reuters conjecture that corporates are giving bond investors the inflation hedge they deserve is at odds with Faulkender’s results. It matches explanation (ii) above, which the data did not support. In my mind, Faulkender’s results are very weak on (ii) because it is very hard to measure this sort of thing. So perhaps these issuers are providing the market something it demands. Right now, however, there is little substantive evidence in favor of the Reuters conjecture and good evidence that company financial officers have all the wrong incentives and are insufficiently monitored and disciplined for gambling on interest rates.

2 Comments

  1. Posted January 26, 2012 at 2:38 am | Permalink

    You may be right. Each management has to look at its own situation. But the post points out that management should also be circumspect. The evidence is that companies overall seem to be speculating. So management should be careful not to be lured for the wrong reason.

  2. Posted January 26, 2012 at 2:28 am | Permalink

    Interesting question. Manufacturing companies are known for “fighting” against inflation that hits their COGS but not necessarily their revenues. It seems issuing floating swaps could be motivated by hedging, not speculation, as long as they are able to lock long term supplier contracts with fixed rates. It is common, at least in some countries, for suppliers to force price increases based on arbitrary inflation adjustments, especially those supplying goods not directly correlated with basic commodities. I don’t have any data to back it up but it might be the reason GE is issuing floaters… From a management perspective being able to “standardize” inflation from suppliers could provide several operational benefits and a common framework to adjust prices while maintaining gross margins.

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: