Is it all about long-term growth or short-term gains? That’s the question some finance professors at Washington University in St. Louis set out to answer when they investigated why non-financial firms are timing the interest rate market. The answer: by swapping short term, flexible interest rates for long term, fixed contracts, or vice-versa, managers may be more likely to meet analysts’ forecasts.
While it may make sense for financial firms to time interest rates, it isn’t as obvious why non-financial firms would do it. Michael Faulkender, co-author of the study and assistant professor of finance at the Olin School of Business, notes that all kinds of companies -technology, service, manufacturing or chemical – do it.
- What types of firms care about paying floating rates now knowing that rates are bound to go up, instead of locking into a rate that stays stable?
“We’re finding firms are swapping for earnings management and for compensation reasons,” Faulkender says. “If a firm is a bit short of its earnings’ forecast, and it changes its debt so that it is paying a one percent interest rate on it this fiscal year instead of four percent, then the firm has reduced its current interest expense and raised its profits.”
By way of example, Faulkender points to Wal-Mart. In 2001, when the term structure was flat, Wal-Mart’s liabilities were heavily tilted towards fixed rate debt and the company only swapped four percent of its debt from fixed to floating. In 2003, when the term structure steepened and there was approximately a 2.5% difference between fixed and floating rates, Wal-Mart swapped about 32 percent of its debt to floating.
In February 2006, Wal-Mart issued a profit warning, indicating that it was going to miss its earnings’ forecast.
“The reason they missed the forecast is primarily due to interest expense, which was approximately $500 million higher because of the increase in interest rates” Faulkender says. “If Wal-Mart had locked in its interest rate and not swapped to a floating rate, then the change in interest rates would have had no impact on their interest expense (other than changes caused by new issuances). But because they swapped to floating and short term rates have risen, their interest expense went up and the company is estimating a hit to earnings of as much as 8 cents a share.”
- Managers contracts can make them especially keen for interest rate swaps.
Faulkender and co-authors Todd Milbourn, associate professor of finance at the Olin School of Business, and Sergey Chernenko (Olin BSBA 2003, now a PhD student at Harvard) also observe a relationship between managers that have a performance-sensitive compensation contract and the timing of interest rate markets. Managers who have stock options or whose contracts are otherwise linked to the firm’s stock market performance are the firms that the researchers find to have derivatives usage that is on average more sensitive to the movements in the interest rate environment.
There’s no reason to believe that firms are creating value when a firm swaps interest rates for speculative purposes (as opposed to hedging), Faulkender says. So there doesn’t appear to be much logic to the practice, especially when most investors would want managers spending time on enhancing a firm’s competitive advantage.
“Do we really think that people in the corporate treasury at IBM or Lucent are better equipped, have better information, and/or better risk bearing capacity to make trades in an interest rate swap that will make them profits at the expense of the hedge funds, mortgage banks or money market funds participating in the market? It’s a zero sum game. Swapping in and of itself does not create value. The only reason such transactions would create value is if they were reducing the risk of the firm, i.e. if the firm were hedging. Timing interest rate swaps based on movements in interest rates is not hedging.”
Editor’s Note: Profesor Faulkender will be available for interviews throughout the month of May, although he will unavailable the week of May 15. Professor Todd MIlbourn is also available for comment. Washington University in St. Louis faculty experts are available for live or taped broadcast quality interviews via our VYVX or ISDN lines at our University Communications studio.