Hedge accounting guidance under GAAP does not always mesh cleanly with market practices related to a derivative strategy and underlying hedged item.
Hedging a forecasted fixed rate debt issuance is an example; those applying hedge accounting for these strategies should be aware of some considerations in order to minimize hedge ineffectiveness on cash flow hedges of these transactions.
Forecasted fixed rate debt issuances are typically hedged with Treasury locks or forward starting interest rate swaps. Based on accounting guidance, these instruments can be designated as cash flow hedges of the variability in either the coupon payments of the forecasted bond issue, or the changes in total proceeds of the bond issue, due to interest rate movements.
A hedge designation under the former scenario implies the bond coupon is variable until the bond issue is priced and the bond proceeds will equal the face/par value of the bond. Meanwhile, a designation under the latter scenario implies the coupon is fixed in advance of the pricing of the bond issue, and proceeds are variable based on rate movements prior to issuance. With most bond pricing conventions, however, both the coupon and the proceeds have some variability prior to the bond pricing date, and the coupon vs. proceeds variability may not be an either/or proposition as the guidance may suggest.
Bonds are usually priced at a yield based on a specific Treasury bond’s yield on the pricing date, plus a credit spread (the impact of the spread is not typically hedged). The total bond proceeds will be equal to the coupon and principal cash flows of the bond discounted at the yield. With typical coupon-setting conventions, the bond coupon may not be exactly equal to the agreed-upon yield, but may, for example, be that yield rounded to the nearest 1/8th of a percent. In the cases where a rounded coupon is different from the bond yield, the proceeds of the bond to the issuer will end up being something other than the face/par value of the bond when the bond’s cash flows are discounted at the yield. This difference in the bond proceeds from par value is another source of variability in the bond issuer’s ultimate interest expense, due to changes in interest rates occurring before the bond pricing date, in addition to the change in the coupon rates occurring in the same period.
For this reason, when designating Treasury locks or forward starting swaps as hedges of forecasted fixed rate debt issuances, hedgers should consider the variability in proceeds as well as coupon payments when measuring the change in the fair value of the hedged item (hypothetical derivative). Inclusion of that variability in the measurement of the hedged item should lead to decreased hedge ineffectiveness, which may be important with these transactions, as they typically have large notional amounts and potential P&L impact.