Liability Management at GMGroup 3ANDRE, CHUN MUN WAIAKHIL BHATNAGARGOH PENG YANG DAVYBrian PARK BONGHEE
Story LineIn Feb. 1992, GM plans to raise U$400M through a public offering Noncallable five-year note, with a fixed interest rate of 7.625%, guided by policy on liability portfolio management, the current structure of its liabilities, and Mr. Bello’s best reading of trends in the bond markets. Engage in a wide range of derivative activities including Interest-rate swaps, Caps, Treasury options or Swap option(Swaptions), based on Mr. Bello’s judgment of the future of interest rates and volatility, the future shape of the yield curve, and the interest- risk exposure
GM’s Financial Policy To ensure the stability of corporate cash flows, to facilitate and support new and existing product plans and other strategic initiatives, and to create and return shareholder value. • GM’s financial policy consisted of a set of targets for key financial management activities, including the management of cash balances, leverage, liability structure, risk management, and dividends
GM’s Liability Management Policies Home Base – matching liabilities to assets • To ensure that the general nature of the firm’s liabilities were closely related to those of its earning assets, so that “any impact on operating cash flow caused by movements in interest rates is largely offset by changes in the value of the firm’s liability portfolio.” Active Management around home base • By adjusting the composition of GM’s liability portfolio in step with changes in rates over time, GM should be able to accomplish a meaningful reduction in total debt service costs.
Rate View February 1992Based on external and internal information, market isuncertain and economy is transitional Interest rates decline due to heavy supply of bonds sold by the U.S. Treasury Bond market rally over the next two months due to weak economy during the first half of the year, high level of uncertainty in the market The yield curve flatten as the spread between long and short rates converged
How changes in interest rates affect GM? High Interest Rate • Increase firm’s borrowing costs affects the profitability • High auto loan, consumer buy less affects revenues Volatile Interest Rate • Changes in the cost of borrowing affect business operations and decision as well as cash flow Auto loan vs. • Negative relationship • 1% increase in the interest rate would Revenues result in a 7.94% drop in revenue Auto loan rate versus revenue (Based on US Federal reserve archives) y = -0.0794x + 12.338, R² = 0.7182 - Passed P-value Test, 71.8% could be explained by the formula. The equation was statistically significant at 95% confidence interval.
Do Nothing (Issuance of $400m debt)Principal ($) 400 Mn Other feature:Fixed Coupon Rate 7.63% 1. No call provisionsInterest to be paid 0.50 (semi annually) 2. No sinking fundSemi annual PaymentAmount ($) 15.25 Mn 3. No right to extend maturityMaturity 5.00 yearsNo. of Payments 10.00Bond Face Value ($) 100.00Issued at Discount 99.98%Notes sold for ($) 99.976 ($ Mn) - 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 Gross Proceeds 399.904 Less: underwritercommission - 1.80 Less: expenses - 0.18 Interest payments - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 Principal repayment -400.00 Net Cash Flow 397.93 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 -415.25 NPV of Cash Flows 397.93 - 14.68 - 14.13 - 13.61 - 13.10 - 12.61 - 12.14 - 11.69 - 11.25 - 10.83 -283.90 Yield Rate 7.902% Bond Issued Receive Pay Fixed Fixed Fixed Fixed Fixed
Do Nothing (Conclusion)• Lock in a coupon rate of 7.63%• Effective cost of capital increases (After underwriter fee and otherexpenses) is 7.902%• Insulate its cash flows fully from any interest rate exposure• Not be able to lower its cost of debt should interest rates decline.
Swaps (Conclusion)Current 6-month LIBOR rate: 4.31%Probability of LIBOR rates below 4%: ~ 0%Swap contracts - unsuitable for insulating GM’scash flows and lowering its cost of capital
Options on Treasury Notes• Call option on 5-year treasury note• Holder has the right to purchase $100 face value of treasurynotes at the end of 60 days at the strike price• Seller receives a premium 5 year Treasury Note: Strike Price ($) Face Value ($) Premium For Bull Spread Yield 98.095 100 0.625 Buy 6.66% 99.045 100 0.328 Sell 6.46%
Options on Treasury Notes Create a bull spread using options on treasury notes5 year Treasury Note:Strike Price ($) Face Value ($) Premium For Bull Spread Yield 98.095 100 0.625 Buy 6.66% 99.045 100 0.328 Sell 6.46% 1.5000 1.0000 0.5000 Buy Sell - Profits 95.00 98.10 99.05 100.00 -0.5000 -1.0000
Options on Treasury NotesBUT WHAT ABOUT MAKING MONEY FROM PREMIUMS???As we expect future yield rate to be high, most probably we will operate below our bullspread Strike Price @ Feb 92, 3 Mo T Premium On Maturity Total Profit Maturity rate (Rf) Buy Sell ($) ($) 100.000 3.80%- 0.629 0.330 0.950 0.651 99.045 3.80%- 0.629 0.330 0.950 0.651 98.095 3.80%- 0.629 0.330 - - 0.299 95.000 3.80%- 0.629 0.330 - - 0.299 • If the price at maturity is above $98.40: reduce the cost of capital to a maximum of 7.88 • if the price is below $98.40: increase its cost of capital to a maximum of 7.92%.
Options on Treasury Notes (Conclusion)•Long term yield curve would flatten (ie. Short term rates willkeep increasing)•Current yield of 5-year Treasury notes was 6.65%.•Long term yield rate to remain high above its current level -supported by the banks’ forecast•Need at least a yield of 6.66%•Price at maturity would operate below the bull spread•Not a suitable instrument to control GM’s interest rateexposure.
Benchmark Caps• Sell an interest-rate cap Exercise Type Maturity (yrs) Price Premium Cap 5 9% 1.77% 2.13% Cap 5 10% 1.06% 1.42%• GM gets a premium which would reduce cost of borrowing• GM obligated to pay any positive difference between LIBOR and ratecap• The cap with an exercise price of 9%: • Premium - $8.52m; cost of capital - 7.37%• Cap with an exercise price of 10%: • Premium - $5.68m; cost of capital - 7.54%
Benchmark Caps Case 1: Write a Call at 9% exercise priceLIBOR @ Exercise Feb 92, OnMaturity Price 3 Mo T Premium Maturity Total Profit rate (Rf) Buy Sell ($) ($) 12% 9% 3.80% 8.531 - 12.000 - 3.47 10% 9% 3.80% 8.531 - 4.000 4.53 9% 9% 3.80% 8.531 - 8.53 7% 9% 3.80% 8.531 - 8.53Case 2: Write a Call at 10% exercise price (65-70% of the time LIBOR is under 10%)LIBOR @ Exercise Feb 92, OnMaturity Price 3 Mo T Premium Maturity Total Profit rate (Rf) Buy Sell ($) ($) 12% 10% 3.80% 5.109 - 8.000 - 2.89 10% 10% 3.80% 5.109 - 5.11 9% 10% 3.80% 5.109 - 5.11 7% 10% 3.80% 5.109 - 5.11
Benchmark Caps (Conclusion)•The probabilities of the caps not being exercised: • 50% (for exercise price of 9%) • 65% (for exercise price of 10%)•Sellinga cap with exercise price of 10% would meet GM’sobjectives about 65% of the time.•Downside risk of unlimited losses at interest rates above 10%make it only a moderately attractive instrument(esp. in the light of expected flattening of the yield curve
SwaptionsExercise period Maturity of swap Fixed rate Premium (in basis point)2 years (2 by 5) 3 yrs 9% 89 – 1083 years (3 by 5) 2 yrs 9% 94 – 111 • An option to enter into an interest-rate swap Bond Issued Receive Pay Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Swap Receive Pay Floating Floating Floating Floating Floating Floating
Swaptions (Conclusion)• 2-by-5 swaption: Premium - $3.56m; Cost of capital - 7.68%• 3-by-5 swaptions: Premium - $3.76m; Cost of capital - 7.66%.• The threshold 6-month LIBOR rates: • 4.7% (for 2-by-5) • 4.82% (for 3-by-5)• Probabilities of making a loss: 40% - 45%• Plausible instruments BUT• Downside risk of unlimited losses at interest rates above9.4%/9.64%• Only moderately attractive instrument
Recommendation• Core principle for risk management -To reduce the variability of GM’s cash flows and lower its expected costs of financial distress• Timing the market to reduce their cost of capital -Grey area between hedging and speculationRecommendation:•To issue the $400m note without any accompanying derivative• Doing nothing meets the core objective of hedging (ie. insulating itscash flow from interest rate risk).• All other alternatives increase the variability of cash flows and servemore towards the objective of lowering the cost of debt• Explore the possibility of issuing a recallable note instead of a plainvanilla one.
Suggested Improvement to GM’s programme• Consolidation of the New York and Detroit Office toreduce duplication of work and could better maximizethe resources.• Clear guidelines for the various offices • Treasurer’s office to set financial targets• Liability management program should be lessspeculative in nature.• Counterparty exposure: • By hedging large sums of debt involves exposure to multiple parties thereby increasing the counterparty risk.