Download Market conditions ripe for new corporate bond issuers 1 May

1 May 2015
Market conditions ripe for
new corporate bond issuers
Funding Risk Revisited
Green Bonds – Funding
Opportunities for
Sustainable Projects
Operating Leases – IRFRS
Changes
Formal Credit Ratings
Foreign Exchange
Intervention; Strategies and
Effectiveness in a New
Zealand context?
Where is volatility and is it
to your advantage?
Hedge Accounting – IFRS 9
Market conditions ripe for new corporate bond
issuers
The rationale for corporate borrowers to issue debt securities to the investor
market in their own name is typically based around tenor, debt source
diversification and pricing. The relatively small numbers of new corporate bond
issues concluded in the domestic debt markets this year have been greeted with
very strong investor demand. Therefore it is a little surprising that completely
new names have not been enticed to raise debt from the local market to achieve
the tenor, diversification and pricing objectives that standard bank debt facilities
do not necessarily offer. Current debt market conditions in terms of investor
demand, credit spreads and tenors offered are arguably the most conducive to
issuers for many a year. Smart debt management is to issue debt when the
investor market desires it, not to be restricting that timing to when existing debt
issues or bank facilities are maturing. Modern bank facilities are easily terminated
at short notice to accommodate this debt management flexibility.
One reason for the shortage of new issuers at this time is that many of the larger
corporate borrowers have already tapped the US Private Placement debt market
for tenors in the 10 to 15 year regions, thus obtaining the lengthier weightedaverage debt term they require.
Whilst renegotiating bank facilities for lower pricing and extended terms may
seem easier to arrange than a new corporate bond issue, borrowers will not need
to be reminded that those who were over-reliant on short-term bank debt
facilities in 2009 learned the hard way about “funding risk”. It would be
surprising that those costly lessons for some New Zealand corporate borrowers
not so long ago have been forgotten about already!
The criteria and attributes required of a borrower to access the domestic
corporate bond market (either as a wholesale private placement or retail issue)
revolve around debt size, security arrangements, tenor required and credit rating.

1
Debt size – diversification of debt funding sources away from banks
becomes a relevant issue when total senior debt increases to more than
Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
$300 to $400 million. Whilst there are examples of borrowers with $200
million of debt issuing a $100 million corporate bond alongside bank debt,
the normal rule of thumb is total core debt above $300 million.

Security arrangements – a Negative Pledge security structure is a
prerequisite for the flexibility that is required to issue corporate
bonds/medium term notes on the same security platform as bank debt.

Tenor required – the underlying driver of issuing a corporate bond is to
achieve the debt tenor not necessarily offered by bank lenders e.g. seven
years. If the economic lives of the balance sheets assets being financed by
debt are long-term in nature, classic funding risk theory suggests long term
debt maturities to match.

Credit rating – Institutional investors require an investment grade credit
rating (BBB- and above) to invest into corporate bonds. A credit rating can
be private and restricted to a selected group of institutional investors if a
wholesale debt placement is being transacted. There are exceptions to this
with Infratil, The Warehouse and Trustpower all successfully raising debt
from the market over recent years without a formal credit rating.
Credit spreads above swap for BBB issues traded in the secondary market have
continued to decline over the last 12 months, indicating the strong investor
demand and a shortage of new issues.
New Zealand BBB-rated senior corporate bonds credit spread to
swap
175
Spread to swap (basis points)
165
155
145
135
125
115
105
95
Mar-13
Jun-13
Sep-13
Data includes a credit rating range
of BBB-, BBB and BBB+ from
month-end bond revaluations
Dec-13
Mar-14
Jun-14
BBB-rated 5 year
Sep-14
Dec-14
BBB-rated 7 year
Current issuers of corporate bonds in the domestic New Zealand debt market are
as follows:-
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Air New Zealand
Port of Tauranga
Auckland International Airport
Precinct Property NZ
Christchurch International Airport
Spark Finance
Contact Energy
Sky Network Television
Fonterra Co-Operative Group
Telstra
Genesis Energy
The Warehouse
Goodman Property Trust
Toyota Finance
IAG
Transpower
Infratil
Trustpower
Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
Kiwi Income Property Trust
University of Canterbury
Meridian Energy
Vector
Mighty River Power
Watercare Services
New Zealand Post
Wellington Airport
Powerco
Z Energy
Funding Risk Revisited
In our December 2014 edition of Treasury Broadsheet our first two
articles focused on debt and credit spreads and concluded as follows;
We believe that credit margins have now reached their sustainable floor and
have recommended to our clients to consider refinancing committed term debt
in the current environment. It is likely that pricing levels will not fall further,
however as the banks are still actively seeking to secure/ grow their balance
sheets, the timing is excellent to use these conditions to improve / renegotiate
more favourable terms and conditions within loan documentation.
We suspect that corporate funding’s extended golden summer is coming to an
end and believe that winter storms are brewing. How long this summer lasts and
how intense the winter storm remains to be seen as central bankers continue
acting as rainmakers.
The following four charts speak volumes in providing a sobering reality test to the
current environment of low corporate credit spreads.
Credit spreads for both Bank and corporate borrowers are back to
pre-GFC levels.
Credit spreads lower than pre GFC
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1 May 2015
Credit spreads lower than pre GFC
Domestic credit growth and offshore markets are pointing toward a
rise in corporate lending margins .
Offshore credit spreads rising
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1 May 2015
Credit growth & credit
spreads divergent
Conclusion
We do not wish to come across as prophets of doom, however, when collectively
viewing the above four charts, it appears to us that a significant rebalancing in
terms of increased credit margins is imminent.
We welcome views and interpretations from our reader base.
Green Bonds – Funding sustainable investments
(Source – Bonds and Climate Change – Sean Kidney CEO Climate Bonds Initiative Fixed-Income Management
Conference - Huntington Beach, California, October 2014)
In World Energy Outlook 2013, the IEA cited the need for a long list of green
infrastructure investments to be undertaken to help avert a climate catastrophe
by 2030. Solar energy, wind, hydroelectric energy, carbon capture, sequestration
for coal, and gas transition and an increase in the use of railways, electric
vehicles, hybrids, and other green modes of transportation were projects
earmarked for immediate action a call to arms of sorts to the global investment
community.
Investors
Pension funds and insurance companies currently invest $88 trillion worldwide
and the majority of this capital is now invested in bond markets. A large share of
the world’s investors are acutely aware of climate change and are interested in
putting their capital to work in climate-related investments—subject to risk and
yield profiles that are competitive with (not necessarily better than) existing
investment opportunities.
At the UN Climate Summit in September 2014, a group of investors representing
$24 trillion of assets under management called for swift action on climate change
and said they stood ready to invest. A separate group, a $19 trillion coalition of
insurance investors representing two-thirds of the world’s insurers, said they
planned to scale up their climate-related investments by a factor of 10 over the
next five years.
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1 May 2015
Borrowers
Green bonds have the same features and characteristics of normal bonds in that
they are a fixed rate instrument use for raising debt capital. The only difference
from conventional bonds is that the proceeds from “Green Bonds” must be used
to fund new or existing projects or assets that generate a net positive
environmental or climate outcome. Any entity can issue a green bond because
the capital raised is relevant to the use of the proceeds only, not whether the
entity is a green organization. This is why many green bonds are linked to
existing rather than new assets.
Green bonds also assist banks and developers fund the more risky development
phase of a project as they have the ability to sell down to “Green” investors post
the construction phase. Green bonds also offer securitization opportunities or the
bundling up of smaller scale projects into a single debt instrument. Because
many green assets are smaller scale in New Zealand (e.g., residential solar panels,
loans for residential energy efficiency building upgrades) securitization could
become a crucial mechanism for smaller scale projects accessing international
debt capital.
Broad green project and asset categories suggested by the principles
include:

Renewable energy

Energy efficiency (including efficient buildings)

Sustainable waste management

Sustainable land use (including sustainable forestry and agriculture)

Biodiversity conservation

Clean transportation

Clean water and/or drinking water
For issuers the benefits of green bonds often outweigh the costs!
Green bonds have some additional transaction cost because issuers must track,
monitor and report on the use of proceeds and most bonds are issued off the back
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
of a formal MTN programme and have generally been investment grade status
(above BBB). However, the largest issuers in Q1 2015 were sub investment grade
Terraform Power (BB-) raised a $800m green bond to finance the acquisition of
renewable energy assets while French recycling company Paprec issued its
inaugural bond; a EUR 480m bond split across two tranches of EUR
185m/$201m (B-) and EUR 295/$321 (B+).
Many issuers, especially repeat green bond issuers, are happy to incur these
additional administration cost due to the following benefits:

The issuance highlights their green assets and business and is a positive
marketing story.

The issuance diversifies their debt investor base (as they can now attract
ESG/RI specialist investors) which often leads to new equity related
investors.

Joins up internal teams in order to do the investor road show
(environmental team with Investor relations and other business).
Types of Green Bonds
In early 2014, a consortium of banks came together to develop the Green Bond
Principles, a set of best-practice guidelines to promote the issuance of green
bonds by corporations. Fifty banks are now involved globally. The Principals set
out two central defining characteristics of green bonds:

It is about green assets, not green entities.

Some measures of transparency on green credentials are provided through
reporting.
Type
Green Bond
Green
Revenue Bond
Green Project
Bond
Green
Securitized
Bond
Proceeds raised by
bond sale
Debt
Recourse
Example
Earmarked for green
projects
Standard/full
recourse to the
issuer; therefore
same credit
rating applies as
to the issuer’s
other bonds
Revenue
streams from
the issuers
though fees,
taxes etc. are the
collateral for the
debt
Recourse is only
to the project’s
assets and
balance sheet
Debt used to fund
energy efficient
upgrades(NABERS
or Homestay rating)
Recourse is to a
group of projects
that have been
grouped
together (i.e.
covered bond or
other structures)
Debt backed by solar
farms or backed by
residential solar
leases
Earmarked for green
projects
Ring-fenced for the
specific underlying
green project(s).
Form of secured bond,
where the security is a
project yet to be
completed.
Either earmarked for (1)
a group of green
projects or (2) specific
green projects within
the group
Debt backed by fees
on electricity bills of
a utility.
Debt backed by a
wind project
Bonds and Climate Changed – The State of the Market in 2014 – Climate Bonds Initiative
http://www.climatebonds.net/files/files/-CB-HSBC-15July2014-A4-final.pdf
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
Formal Credit Ratings
Securing a formal credit rating from Standard & Poor’s, Moody’s, or Fitch can be
a beneficial exercise in achieving a wider investor base and in improving
corporate compliance and financial discipline. The process is relatively straight
forward, albeit time consuming for management, however the financial rigour the
process brings is often very beneficial for companies.
The process explained below is for Moody’s Investor Services; however it is
similar in nature to the process followed by Standard & Poor’s, and Fitch.
Moody’s Credit rating
A credit rating is a forward-looking opinion regarding creditworthiness. It uses a
defined ranking system of categories based on information obtained by Moody’s
from Issuers, their Agents and independent sources.
The information provided must be true, accurate, timely, complete and not
misleading and the ratings are managed through-the-cycle. The commercial and
credit responsibilities within Moody’s are segregated to safeguard the
independence, integrity and quality of the ratings process with the commercial
Group within managing all commercial relationships with issuers seeking ratings
services and the Analytical Group determining and monitoring ratings.
Benefits of a Credit Rating
1.
Improves access to funding –liquidity and cost
2.
Raises corporate profile
3.
Demonstrates transparency
4.
Provides investors with independent opinion on credit risk
5.
Promotes market stability
6.
Provides global comparability
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1 May 2015
1.
Rating Application
introductory meeting or teleconference with the commercial group to
introduce Moody’s ratings process, methodology and products. Analysts will
often attend at this stage and there is no obligation or commitments
required from the Issuer. When the issuer is ready to proceed, a fee proposal
is agreed and a ratings application will be completed. The rating process
only commences once an executed application is received.
2.
Analytical Team Assigned
Moody’s will then assign a lead and back-up analyst to the customer. The
analysts assigned will be sector and industry specialists and must clear an
internal conflict attestation check prior to beginning the analysis.
3.
Provision of Information
The customer will be asked to provide relevant financial and non-financial
information. The information requested may vary according to the sector
and available market information
4.
Management Meeting
An initial management meeting is generally held at the company’s head
office and then may be site visits to review assets and operations. The lead
analyst will discuss the meeting agenda with the customer in advance of the
meeting and generally covers off:
5.

Background and history of the company/entity

Industry/sector trends

Political and regulatory environment

Management policies, experience, track record, risk appetite

Basic operating and competitive position

Corporate strategy and competitive philosophy

Debt profile-Financial position and sources of liquidity
Analysis
Following the management meeting, Moody’s will analyse the information
provided by the customer and obtain follow up information and clarification
from the customer as necessary. Upon completion of the analysis, the lead
analyst will contact the customer to ensure the facts are correct and
understood before making a recommendation to a Moody’s rating
committee.
6.
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Rating Committee
The lead analyst will convene a rating committee once the team has
completed its analysis. The rating committee will comprise of a number of
credit risk professionals with appropriate knowledge and experience to
address all of the analytical perspectives relevant to the customer. The
analyst will determine who to include based on the size of the customer, the
complexity of the credit analysis and whether rating the customer introduces
a new instrument to market. The role of the lead analyst at the rating
committee meeting is to present the rating recommendation and rationale,
and to ensure that all relevant issues related to the credit are presented and
discussed. Rating committee discussions are strictly confidential and only
certain Moody’s analysts may serve on rating committees.
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1 May 2015
7.
Rating Notification
Rating committee makes its decision and the Lead analyst communicates
the rating and Moody’s rationale to the customer. A final verification is
undertaken with the customer that the intended press release is factually
correct and does not contain confidential information.
8.
Rating Dissemination
Moody’s disseminates new ratings via press release to the major newswires
with Press release simultaneously posted on Moody’s global website
www.moodys.comas well as relevant regional and local Moody’s websites.
9.
Surveillance
Once published, Moody’s ratings are continuously monitored and updated.
The rating process involves active, ongoing dialogue between the customer
and Moody’s analysts. Following the assignment and publication of the
rating, Moody’s meets management periodically as events and industry
developments warrant. The Moody’s analyst will maintain regular contact
with the customer and will be available to respond to a customer’s needs or
questions. Customers are encouraged to raise any concerns and present all
material that is pertinent to the ongoing analysis. Moody’s will issue press
releases to announce any subsequent rating actions or outlook changes.
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1 May 2015
10.
Types of Credit ratings
Customer
Needs
Requirement
Disclosure
MIS Product Solution
Product Description
A monitored credit rating that is made available to the requesting issuer and certain of its advisors
on a confidential basis through a secure dataroom.
Interest in
Corporate
Credit Profile
Public
Public Rating
Subject to similar information requirements and rating committee procedures that apply to MIS’s
public ratings.
Issuer / Entity
Rating
Rating on all Debt
Instruments
Private
Private Monitored
Ratings (PMR)
A monitored credit rating that is publicly available on moodys.com
Public
Public Rating
A monitored credit rating that is publicly available on moodys.com
Public
Public Monitored Loan
Rating
Unpublished
Unpublished Monitored
Loan Rating (UMLR)
Public
Public Monitored Private
Placement Ratings
Unpublished
Unpublished Monitored
Private Placement
Rating (UMPPR)
A monitored credit rating on all loan facilities within the credit agreement.
Rating on Loan or
Bank Credit Facility
Rating
Financing
Can be either published on moodys.com or made available to existing and prospective lenders
through a secure dataroom on a non-selective basis.
Unpublished ratings are monitored credit rating which is distributed to eligible investors on a nonselective basis via an electronic platform
A monitored credit rating on private placement debt instrument.
Rating on Private
Placement Debt
Instruments
Can either be published on moodys.com or made available to existing and prospective investors
through a secure dataroom to existing and prospective investors on a non-selective basis.
Unpublished ratings are monitored credit rating which is distributed to eligible investors on a nonselective basis via an electronic platform
A point in-time analytical service provided via a confidential letter to unrated issuers
contemplating a debt issuance.
Preliminary View on
Prospective Issuance
Private
Indicative Rating
Indicative Rating is determined by a rating committee, but is not a definitive credit rating.
Indicative rating is the opinion of a potential credit rating based upon a proposed issuance.
Prospective
Financing
View on
Hypothetical
Scenarios
Private
Rating Assessment
Service (RAS)
A point-in-time assessment for up to three detailed and distinct hypothetical scenarios pertaining
to credit transforming events such as M&A, divestitures, etc. Potential for further additional
scenario analysis.
RAS feedback is provided via confidential letter with the conditional ability to share with advisors.
MIS will not assist an issuer in designing or constructing scenarios.
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
Operating Leases – Latest developments
The two most relevant releases for Q1 2015 are:
1.
Leases: Practical implications of the new Leases Standard – IFRS -March 2015
http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/Practical-implications-Leases-Standard-Project-Update-March-2015.pdf
Overview -The paper compares the IASB’s lessee accounting model and compares it to the FASB’s model, highlighting the similarities and differences while
providing an overview of some of the possible effects of the forthcoming changes to lessee accounting. The IASB plans to issue the new Leases Standard before the end
of 2015.
Key Takeaways - Expands on the jointly published Exposure Draft Leases (the 2013 ED) in May 2013 which requires a lessee to:

Recognise lease assets and liabilities on the balance sheet, initially measured at the present value of unavoidable lease payments to reflect the flexibility obtained by a
lessee - lease liabilities include only economically unavoidable payments

Recognise amortisation of lease assets and interest on lease liabilities over the lease term; and

Separate the total amount of cash paid into a principal portion (presented within financing activities) and interest (presented within either operating or financing
activities).
Comments
Metric affected
Assets (+)
Liabilities (+)
Equity Operating Profit (+),
EBITDA (+)
Operating cashflow (+),
Financing cashflow ( -)
Debt / EBITDA (+),
Interest cover ratio (-)
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For lessees that currently have material off balance sheet leases, the most significant effect of the new Leases
Standard will be an increase in lease assets and financial liabilities.
Equity to reduce over time as the carrying amount of lease assets will typically reduce more quickly than the
carrying amount of lease liabilities. This will result in a reduction in reported equity compared to today for
lessees with material off balance sheet leases.
Under the IASB model, a lessee will present the implicit interest in former off balance sheet lease payments as
part of finance costs whereas, today, the entire off balance sheet lease expense is included as part of operating
costs.
The IASB model reduces operating cash outflows, with a corresponding increase in financing cash outflows,
compared to the amounts reported today and under the FASB model. This is because, currently, lessee’s
present cash outflows on off balance sheet leases as operating activities whereas, under the IASB model,
principal repayments on all lease liabilities will be included within financing activities. Interest can also be
included within financing activities under IFRS.
The changes to lease accounting could affect some debt covenants and they could result in some entities no
longer complying with debt covenants upon application of the new Leases standard if
those covenants are linked to an entity’s IFRS financial statements (without adjustments for off
Balance sheet leases). Many debt covenants in existing financing facilities would not be directly affected by a
change in accounting requirements e.g. IFRS does not define terms such as ‘debt’ and ‘EBITDA’ and historic
covenants are often based on the accounting requirements in place at the time of signing the loan agreements.
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1 May 2015
2.
Proposed Updates to Standard Adjustments in the Analysis of
Companies’ Financial Statements - Moody’s Investors Service April
15 2015
Overview
Moody’s are currently seeking feedback on proposed changes to how they
calculate the amounts by which they adjust the balance sheet and income
statement for operating leases.
Key Takeaways
Moody’s current approach for capitalizing operating leases focuses mainly on a
multiple of annual rent. Multiples vary by sector and were established to replicate
a scenario in which a company borrows money to buy assets rather than leasing
them. They then calculate a capitalized debt amount (adjusting assets by the
same amount) by applying the relevant industry sector multiple, which is derived
from estimating the remaining useful life typical for leased assets in each sector.
The adjustment to debt (and assets) is the higher of this amount or a Moody’s
calculation of the present value of minimum lease commitments.
The proposed adjustment to the balance sheet would use an estimate of the
present value of committed lease liabilities, with a built in floor and cap to
enhance comparability where companies have very short or very long lease
tenors. Like the current approach, the adjustment will increase balance sheet
debt and fixed assets by an amount that equals the greater of:

A sector multiple (reset) times annual rent expense, or

The present value of minimum lease commitments (discounted by an
intermediate term interest rate based on the issuer’s rating), with a cap
The proposed approach reflects the view that the credit impact of leases should
recognize that companies have greater legal and financial flexibility when
employing operating leases than would be the case if they had issued debt to
finance the purchase of the same assets. The proposed approach focuses on the
minimum legal obligation under lease commitments. The current adjustment
reclassifies one-third of rent expense to interest expense and the remaining twothirds to depreciation expense. The adjustment would continue to reclassify rent
expense to interest and depreciation expense but using a different calculation:

Lease Interest Expense = Lease debt x an intermediate term interest rate
based on the issuer’s rating (capped at rent expense)

Lease Depreciation Expense = Rent Expense – Lease Interest Expense
The purpose of the new sector multiples is to establish a minimum floor amount
for the debt adjustment. The proposed use of a floor reflects Moody’s view that
companies with very short lease tenors will normally renew most of these leases
in order to continue to utilize the assets. The new multiples would range from 36x, instead of 5-8x currently, with most sectors using a multiple of 3x. The
present value calculation would also be subject to a cap of 10x annual rent
expense, effectively limiting the debt adjustment for companies with very long
lease tenors. The proposed use of a cap reflects Moody’s view that leases with
very long terms are typically more conditional and can often be renegotiated.
Sectors that would see the greatest average change in total adjusted debt include
retail, apparel, restaurants, shipping, airlines and consumer services. Moody’s
expect most, but not all, rating upgrades to occur in the industries with
proportionally large amounts of operating leases. Upgrades are expected to be
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1 May 2015
limited to one notch, although there could be a few multi-notch upgrades. . Few if
any downgrades are expected to result from this change in methodology.
For the majority of companies the proposed change would result in lower interest
expense, and lower EBIT and EBITA due to the increased allocation to
depreciation expense, which would also cause declines in profitability margins
using EBIT and EBITA. In the overwhelming majority of cases, the reduction in
interest expense would be proportionately greater than the reduction in EBIT and
EBITA. This would result in improvements in interest coverage measures such as
EBIT / interest expense and EBITA / interest expense.
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
Foreign Exchange Intervention; Strategies and
Effectiveness in a New Zealand context
(Note: This article was written before the April 30 RBNZ OCR Review)
With the NZD Trade Weighted Index (“TWI”) trading near record highs above
79.00, it is an interesting time to consider a recent Bank for International
Settlement (“BIS”) publication1 regarding the strategies and effectiveness of global
central bank foreign exchange intervention, and linking back to our own central
bank.
New Zealand Background
Our own central bank, the Reserve Bank of New Zealand (“RBNZ”), ‘intervenes’
infrequently in foreign exchange markets by buying and selling foreign currency
denominated assets including cash, marketable securities and derivatives.
According to published information, the RBNZ last did this in any volume (sold
NZD521m) in August 2014 when the NZD TWI was trading above 79.00. The RBNZ
publishes monthly data (with a one month lag) showing the net value of outright
sales and purchases of NZD during the month. The net sum of these transactions
(excluding the sale of NZD in respect of the Bank’s foreign currency denominated
operating expenses) represents RBNZ foreign exchange intervention.
Officially, the RBNNZ has four criteria to meet before intervening in foreign
exchange markets:
The exchange rate must be exceptionally high or low;

The exchange rate must be unjustified by economic fundamentals;

Intervention must be consistent with the Policy Targets Agreement.

Conditions in markets must be opportune and allow intervention a
reasonable chance of success.
Recent RBNZ Monetary Policy Statements and Official Cash Rate Reviews have
characterised the NZD value as unjustified in terms of current economic
conditions, particularly export prices, and unsustainable in terms of New Zealand’s
long-term economic fundamentals.
Global Research and Evidence, also considered in a New Zealand
context
Referencing the Bank for International Settlements (“BIS”) paper, two intervention
rules are considered; leaning against exchange rate misalignment and leaning
against the wind.

Leaning against exchange rate misalignment is aimed at bringing the
exchange rate closer to its ‘equilibrium’ level.

Leaning against the wind represents attempting to change the direction the
exchange rate is moving.
Practise of our own RBNZ is more consistent with leaning against misalignment,
i.e. the first of these approaches. The BIS assess the effectiveness of these two rules
against a range of criteria including stabilising the exchange rate, discouraging
speculation and limiting intervention costs. The BIS contend that where
intervention may reduce foreign exchange volatility it can reduce risks to
speculators thereby actually leading to greater speculation.
1
Foreign exchange intervention: strategies and effectiveness. By Nuttathum Chutasripanich
and James Yetman, March 2015.
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1 May 2015
The BIS paper also finds central bank uncertainty about the fundamental level of
the exchange rate can result in intervention being less efficient. Conversely, leaning
against the direction the exchange rate is moving, avoids having to estimate the
fundamental value but may encourage speculation (presumably by re-presenting
better ‘levels’ for speculators to re-set positions). Interestingly, the research also
finds the costs of intervention will be large when exchange rate movements are
driven by shocks to interest rate differentials; one can draw parallels here to the
New Zealand interest rate environment relative to that of most of our peer trading
partners.
A 2013 BIS survey indicates the most common reason for (emerging market)
central banks intervening in foreign exchange markets was to limit exchange rate
volatility and smooth the ‘trend’ path of the exchange rate. Evidence of RBNZ
communications and practise have been consistent with attempting to moving the
exchange rate back towards a desired level once a turn in the exchange rate has
occurred.
The BIS paper also indicates different channels by which foreign exchange
intervention can work.

The portfolio-balance channel (mainly in economies with relatively
closed financial markets) where supply and demand of financial assets is
influenced to result in other market participants rebalancing their financial
asset portfolios. This does not appear the motivation of the RBNZ.

Order-flow (or microstructure) channel where the central bank is
perceived to have better information (as the only market participant with a
complete picture of market activity) therefore can shape the market. Given
the size of transactions necessary, and other reasons, this is unlikely to be the
motivation and approach of the RBNZ.

Signalling (or expectations) channel which works through the
adjustment of expectations around future central bank policy. Transactions
may be interpreted as setting a precedent for future interventions, or
revealing information about the level of the exchange rate considered
desirable by policy makers. Such an approach has been successfully by used
the Reserve Bank of Australia over the last year or more, on a verbal and
non-subtle basis attempting to talk the market towards a level they see as
justified.
The BIS also note an approach of ‘secret’ intervention where intervention is
conducted but not communicated with this is of only limited effectiveness as it does
not allow for the signalling impact above. This has relevance for the RBNZ
approach, where not only can the RBNZ modestly influence the level of the
exchange rate through timely NZD selling, it can have a more significant effect
when intervention is subsequently ‘announced’ a month later. A separate research
paper quoted by BIS indicates that for maximum impact ‘secret’ intervention must
be large and timed ‘with the wind’. Referencing back to RBNZ activity we would
observe this occurs once the tide has turned, akin to giving the exchange rate a
further push once momentum has swung from upward to downward, with the
added ‘kicker’ of subsequent announcement.
The BIS note surveys of central banks generally support intervention as being
effective. In contrast, studies of effectiveness of foreign exchange intervention
outside of central banks are mixed, and may actually increase short-term volatility.
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New Zealand Summary
Linking back to our own central bank, PwC would contend, and the RBNZ appears
to accept, that foreign exchange ‘intervention’ cannot have a significant,
permanent, trend-changing impact on the NZD. However at times of turning points
in cycles and when there are periods of “over- valuation”, timely NZD selling once a
change in momentum has occurred may push the exchange rate further lower.
Furthermore, in addition to actual well timed activity on the day, the subsequent
announcement of intervention may re-inforce the movement lower through its
signalling context.
Such modest, but still potentially helpful, conclusions around effectiveness in a
New Zealand context appear consistent with the recent BIS literature.
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
Where is volatility and is it to your advantage?
Over recent years market volatility has remained relatively low despite greater
uncertainty to global economic growth and financial market stability.
Volatility is the primary measure of risk for any investor (relative to specific
returns). Assessing the trend in market volatility might shed light on both its
current state and future direction. Conventional wisdom is that periods of high
volatility is broadly commensurate with difficulty in generating and sustaining
returns.
Volatility is also one of the key factors influencing option pricing (for risk
management instruments such as purchased call options). The recent PwC treasury
survey results highlighted reluctance in using options within the risk management
toolkit. Therefore, assessing current levels of volatility might also assist on whether
the premium cost of options provide economic value as a risk management
instrument.
To provide context, there exist good positive correlations across various asset class
volatility measures. The following are provided: equities (VIX index), bonds
(MOVE index), and foreign exchange (EUR/USD one-month implied ATM
volatility).
VIX index
VIX index
Move index
Foreign exchange
76%
74%
Move index
76%
Foreign exchange
74%
61%
(51)%
(57)%
S&P 500
61%
(46)%
*VIX and MOVE since 1995, FX since 1999
As the table shows, market volatility also tends to move inversely to financial
markets. Consequently, it is also broadly recognised that recessions tend to drive
increased volatility. Macro-economic research has expanded further upon this with
linkages to market volatility attributed (but not limited) to the following:

High inflation

Slow growth
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015

High interest rate volatility

High growth volatility

High volatility in inflation rates
Interesting then, despite the biggest market shock and global recession in over 80years, market volatility has moved lower to levels pre-Global Financial Crisis
(GFC). Arguably we do not reside in normal times of functioning markets and
efficient capital allocation.
The current environment can be explained by central bank action and the
significant amounts of Quantitative Easing (liquidity) injected in order to keep
financial markets functioning. Since 2007, central bank balance sheets have
ballooned in size by over 250% (on average across the Fed, ECB, BoJ and BoE). In
providing an unprecedented amount of liquidity as the backstop (“to do whatever it
takes”) central banks have provided the critical reduction in volatility.
A distribution of market volatility measures (equity, bonds, foreign exchange) show
the period pre-GFC (up to 2007) as being broadly normally distributed. However,
when viewing post-GFC distributions, instances of volatility gravitate to below the
long-term average. The VIX and MOVE index continue to be characterised by this.
EUR/USD foreign exchange option volatility has increased since the start of 2015
(following the start of the ECB’s Quantitative Easing), however equity and bond
market volatility continue to remain low.
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1 May 2015
So where are we? We assess that present levels of volatility remain low in the
context of history; however the writing is on the wall. In the current environment
central banks are fighting to keep interest rates low for as long as possible.
Therefore an extension of this is that volatility will also remain low, but with US
interest rates set to inevitably rise, low levels of volatility cannot remain indefinite.
What this also infers is that options continue to remain a compelling instrument to
hedge financial market risk. Purchased options (such as a borrower interest rate
cap) might offer the best form of interest rate certainty given the overall low setting
of interest rates and uncertain outlook.
If volatility is low reducing the premium cost, reluctance in the use of options might
therefore be alieved if the result is hedging at sensible rates that also make
economic sense from a cost of funds perspective.
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Treasury Broadsheet | Quarterly newsletter of snippets and stories from the world of treasury management
1 May 2015
Hedge Accounting – IFRS 9
A fundamental issue with the existing standard for hedge accounting IAS 39
Financial Instruments: Recognition and Measurement (IAS 39) is that the
requirements of the standard do not always align with common risk management
practices, which has frustrated many corporate treasurers.
The recent 2015 PwC New Zealand Treasury Management Survey found a decline
in the popularity of hedge accounting, which itself is somewhat of a surprise. One
would think that the benefits of hedge accounting would have prevailed following
the heightened attention to earnings volatility following the Global Financial Crisis.
Furthermore, while IAS 39 is associated with a steep learning curve, it has been
around for some time now and with IFRS 9 Financial Instruments (IFRS 9) now
available for early adoption, one would expect this to be less of an issue. Also, with
cost effective treasury management systems available that can remove much of the
administrative burden of hedge accounting, one could say that its popularity should
have increased. Survey respondents who did not hedge account said that the key
reasons were the fact that IAS 39 had an immaterial impact, was restrictive,
complicated and an administrative burden.
The International Accounting Standards Board issued IFRS 9 in November 2013,
and this will be effective for accounting periods starting on or after 1 January 2018.
The new standard replaces IAS 39 and aligns hedge accounting more closely with
risk management. Generally speaking, IFRS 9 simplifies the rules in relation to
hedge accounting and therefore makes it easier to achieve hedge effectiveness.
IFRS 9 is quite broad and covers a wide range of aspects but, in my opinion, some
of the more noteworthy points are as follows:

The removal of the 80%-125% bright line hedge effectiveness test. That is,
hedge effectiveness can be achieved even where the effectiveness ratio is
outside these thresholds. However, any actual ineffectiveness must still flow
through the profit and loss.

Relaxing the rules on hedge accounting for purchased options as hedging
instruments. Currently, under IAS 39, either the entire fair value or only the
intrinsic value of the option can be designated. Usually, only the intrinsic
value is designated as fluctuations in the time value can potentially lead to
ineffectiveness and possibly a breach of the 80%-125% effectiveness rule. In
this instance, the changes in the time value component are recognised in the
profit and loss which can create volatility. IFRS 9 proposes that the initial
time value (i.e. the premium paid) will be recognised in the profit or loss
either over the period of the hedge if the hedge is time related, or when the
hedged transaction affects profit or loss if the hedge is transaction related.
Any changes in the option’s fair value associated with the time value will only
be recognised in other comprehensive income, which should result in less
volatility in the profit or loss.
Overall, the new standard should provide a better basis for aligning hedge
accounting with risk management and should remove some of the complexity and
administrative burden of IAS 39. The 2015 PwC New Zealand Treasury
Management Survey found that the majority (66%) of respondents who currently
hedge account are either planning to early adopt IFRS 9 or are at least considering
it. If you are currently applying the hedge accounting standard and have not
considered early adoption of IFRS 9, it may be something you should think about.
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1 May 2015
Get in touch
Stuart Henderson
Partner
T: +64 9 425 0158
M:+64 21 343 423
E:[email protected]
Roger Kerr
Partner
T: +64 9 355 8181
M:+64 21 935 288
E: [email protected]
Brett Johanson
Partner
T: +64 4 462 7234
M:+64 21 771 574
E: [email protected]
Chris Hedley
Director
T: +64 9 355 8183
M: +64 21 479 680
E: [email protected]
James McHardy
Director
T: +64 9 355 8342
M: +64 21 263 4282
E: [email protected]
Jason Bligh
Associate Director
T: +64 4 462 7265
M: +64 21 386 863
E: [email protected]
Alex Wondergem
Manager
T: +64 9 355 8252
M: +64 21 041 2127
E: [email protected]
Tom Lawson
Treasury Advisor
T: +64 9 355 8284
E: [email protected]
Mahesh Chhagan
Treasury Analyst
T: +64 9 355 8301
Freddy Greenslade
Treasury Analyst
T: + 64 9 355 8723
E:[email protected]
E: [email protected]
Daniel Sharp
Treasury Analyst
T: +64 9 355 8865
E: [email protected]
Dylan Queen
Treasury Analyst
T: + 64 4 462 7209
E: [email protected]
pwc.co.nz /corporate-treasury-advisory-services/
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