Euro-Denominated Debt as a Net Investment Hedge: Good Idea?
With three-month EURIBOR negative, more and more U.S.-based companies are seriously considering Euro-denominated debt as a less expensive way to re-finance their U.S. dollar debt.
It’s a strategy that seems to make sense; after all you’re “being paid” to borrow in Euros, and adding negative interest rates to your credit spread will provide lower borrowing costs (at least in the short run). The problem is that lower interest cost isn’t the whole story.
EUR debt would generally create rather large FX gains and losses as the EUR value changes. To combat this, it’s common for companies to designate the trades under ASC 815 as a “net investment hedge.” This allows the spot to spot FX Gain/Loss associated with the Euro debt to be classified as a Cumulative Translation Adjustment – showing up in equity, rather than in income. This is only feasible if you have net investment positions in EUR subsidiaries that equal or exceed the debt notional; in one cautionary tale, a company executed debt with the intention of designating it as a net investment only to find – post EUR debt issuance – that they had accidentally borrowed more than they could actually designate as a net investment hedge. This created a big problem in earnings.
Although EUR interest rates are negative, the addition of a company’s credit spread generally results in borrowing cost (rather than income) and granted that these costs are lower than U.S. borrowing costs when the EUR is trading at 1.10, the company should evaluate the potential interest expense should EUR return to 1.40 (or higher) over the remaining tenor of the debt. This, of course, is not a problem at all if the EUR revisits .80.
A related problem that is frequently not considered thoughtfully enough until the maturity of the transaction, is that repayment of principal must occur in Euros. The EUR repayment will work well economically if the company accumulates profits in EUR with which to repay the loan.
Years ago, yield enhancement (rather than negative interest rates) had lured companies into net investment hedging generally using swaps (cross currency interest rate swaps can be used to synthetically convert USD debt to EUR debt*). In one disconcerting case, a company had executed a substantial cross currency interest rate swap when JPY was trading at 120 – but had to net settle the principal repayment at the end of the swap 10 years later when the JPY was trading at 80 – requiring the company to substantially increase its USD borrowings. Had the swap been for JPY120B ($100M), the net settlement on the final exchange of principal would have been a $50M loss (50 percent of the original loan value). If we convert that logic to a borrowing rather than a swap, the company would have needed to repay a JPY loan with an initial value of $100M with $150M at maturity. (However, it is true there would have been interest income over the life of the swap.)
Thus, parties contemplating EUR issuances should be sure they will have enough Euro cash flow to pay off the debt in the event the EUR has appreciated by the due date rather than trusting or hoping that the EUR won’t be stronger than today.
Is attempting to take advantage of negative short-term EURIBOR rates to reduce interest expense a bad idea? Not necessarily. But it isn’t a strategy to be taken lightly, as the effects may go well beyond lower interest expense.
* Companies may also consider cross currency swaps of their net investment: synthetically turning their USD debt into EUR and designating it as a net investment hedge. Unfortunately the positive impacts of the EUR interest expense are buried in Cumulative Translation Adjustment and are therefore less attractive for financial reporting purposes.
Want to understand more about whether EUR borrowings are right for your company? We’re happy to help. Contact Hedge Trackers today, or call us at 408-350-8580.