A recent paper from NERA Economic Consulting seeks to demystify interest rate swaps and other interest rate derivatives.
This paper reviews the economics of interest rate swaps and other interest rate derivatives. We begin by illustrating how interest rate swaps work and how they can be used to expand the set of financing options available to a company, to manage exposure to interest rate risks, and to speculate on interest rate expectations. Using recent municipal swaps as an example, we then illustrate potential issues of contention between swap counterparties and review the economic principles behind them.
While interest rate swaps offer a borrower potential cost savings justifiable on economic grounds, they may also expose him to risks not present in other financing alternatives.
For example, a borrower that issues revolving debt and enters into a swap to hedge against interest rate changes is not in the same position of a borrower that borrows long-term at the same rate. The former is subject to changes in his credit risk whereas the latter is not. The Jefferson County, Alabama case reviewed in this paper is an example of a realization of this risk.
When interest rate swaps are used to hedge a company’s exposure to interest rate risk, their ex-post performance in terms of financing costs may be inferior to an alternative that leaves a borrower exposed to interest rate risk. We argue that the economic soundness of a swap should be evaluated on an ex-ante basis, taking into account its risk-return trade-off relative to alternative financing options.
We also review some common swap pricing practices important in determining the value of a swap and understanding swap-dealer fees. While a standard principle in swap pricing is the mid-market pricing, or zero net present value, in practice the net present value of a swap at inception is positive for a dealer. We review the main adjustments dealers make to arrive at a fair market value, including credit risk, profit margins, and liquidity adjustments. The adjustments should rely on sound economic models, and the models should make appropriate risk adjustments to expected losses and expected defaults.
For details, see Demystifying Financial Derivatives: Interest Rate Swaps and Municipal Derivatives (Complimentary)
Sharply higher prices for oil and natural gas liquids (NGLs) have boosted business conditions for the independent exploration and production (E&P) industry, and should remain high well into 2012, offsetting persistently weak natural gas prices, according to Moody’s.
Companies that focus on oil and NGL production are poised to see particular benefits through 2012—even as a shale-based supply glut continues to depress natural gas prices in North America, Moody’s says in its new industry outlook for the E&P sector. Oil- or NGL-focused producers such as Nexen (Baa3, negative), Whiting Petroleum (Ba2, stable) and Continental Resources (Ba3, positive) will benefit from these high prices through mid-2012. By contrast, natural gas-oriented E&Ps such as EnCana (Baa2, stable), EQT (Baa1, negative), Southwestern Energy (Ba1, positive) and QEP (Ba1, stable) could face some margin pressure.
The independent E&P industry is now in the midst of one of its most advantageous stretches in recent years, with oil offsetting weak natural gas prices and outpacing the rising costs of oilfield services and other expenses, -Terry Marshall, Moody’s
E&Ps have seen oil prices at historically high levels in recent months, due in part to political unrest in the Middle East and North Africa. Moody’s expects these prices to remain high through 2012. By early 2011, North American oil rig counts had reached their highest levels in 25 years as E&Ps raced to boost production of high-priced crude and NGLs.
In their rush to boost production, many E&Ps are spending beyond their cash flow, the report says. Some are raising new capital by pursuing joint ventures, while others are tapping the debt markets for funding.
Natural gas prices will remain depressed over the near term, with new technologies increasing production and reserves in North America, resulting in a significant supply glut.
Moody’s recently revised its outlook for the global independent exploration and production sector to positive from stable, reflecting the ratings agency’s expectations for high oil and NGL prices well into 2012, offsetting persistent weak natural gas prices. A collapse in oil prices could bring the outlook back to stable—or even negative, in the case of a swift and severe drop.
Industry Outlook, Historically High Oil Prices Spur Production Push, Outpacing Escalating Costs for E&Ps,” is available at the Alacra Store.
Moody’s placed the long-term ratings of Exelon under review for possible downgrade following today’s announced plan to merge with Constellation Energy Group, while both Standard & Poor’s and Fitch Ratings affirmed their ratings.
Moody’s Investors Service placed the long-term ratings of Exelon Corporation (EXC: Baa1 senior unsecured) and Exelon Generation Company, LLC (ExGen: A3 senior unsecured) under review for possible downgrade following today’s announced plan to merge with Constellation Energy Group, Inc. (CEG: Baa3 senior unsecured) in a stock-for-stock transaction.
Concurrent with this rating action, Moody’s affirmed all of the ratings of CEG and changed CEG’s rating outlook to positive from stable. EXC and ExGen’s short-term ratings for commercial paper are affirmed at Prime-2, while CEG’s short-term rating for commercial paper is affirmed at Prime-3.
“The rating review for EXC and ExGen reflects the pending acquisition of a lower-rated entity and the expected increase in leverage, particularly off-balance sheet debt, at a time when electric margins are compressed,” said Moody’s Senior Vice President A.J. Sabatelle.
At the same time, Moody’s affirmed all of the ratings for EXC’s regulated subsidiaries and their subsidiaries and maintained the stable rating outlook at Commonwealth Edison Company (CWE: Baa3 senior unsecured), PECO Energy Company (PECO: A3 senior unsecured), ComEd Financing III (Ba1 subordinated debt) and PECO Energy Capital Trust III (Baa1 subordinated debt). Moody’s also affirmed all of the ratings of Baltimore Gas and Electric Company (BGE: Baa2 senior unsecured) and subsidiary, BGE Capital Trust II (Baa3 subordinated debt). The rating outlook for BGE and BGE Capital Trust II is positive.
For details see Moody’s reviews Exelon and Exelon Generation for possible downgrade; Affirms Constellation, outlook positive
S&P: Ratings Are Affirmed On Exelon After News It Will Merge With Constellation; Constellation Is On CW Positive
Fitch Affirms Ratings of Exelon & Constellation Following Merger Announcement
Visit Alacra Pulse for details of the Exelon-Constellation merger.
Fitch Ratings is more positive than Standard & Poor’s on the impact on Japanese insurers of the earthquake and Tsunami.
Fitch affirmed nine Japanese life insurers’ Insurer Financial Strength (IFS) Ratings, following the agency’s ‘core’ & ’severe’ stress test of the impact of the Great East Japan Earthquake and tsunami as well as stock market volatility in its aftermath. The Outlook on all of the ratings is Stable.
The nine insurers are Nippon Life Insurance Company (IFS ‘A+’/Stable), Dai-ichi Life Insurance Company, Limited (IFS ‘A’/Stable), Meiji Yasuda Life Insurance Company (IFS ‘A’/Stable), Sumitomo Life Insurance Company (IFS ‘A-’/Stable), Daido Life Insurance Company (IFS ‘A+’/Stable), Taiyo Life Insurance Company (IFS ‘A-’/Stable), Mitsui Life Insurance Company Limited (IFS ‘BBB-’/Stable), Asahi Mutual Life Insurance Co. (IFS ‘BB’/Stable) and Fukoku Mutual Life Insurance Co. (IFS ‘A’/Stable).
The Fitch stress test results indicate that the Japanese life insurers’ capitalisation is more than sufficient to cover the expected loss estimates even under the Fitch ’severe’ scenario coupled with stock market volatility.
Fitch would expect the insured losses to be absorbed by the insurers’ annual core profits without negatively affecting capitalisation, unless the actual ultimate losses turn out to be materially larger than the amount assumed in Fitch’s ’severe’ stress scenario.
The full list of rating actions is provided in Fitch Affirms 9 Japanese Life Insurers’ Ratings After Earthquake Stress Test; Outlook Stable
S&P yesterday revised the outlook for eight Japanese insurers to Negative.
Fitch Ratings says that although its outlook for the Tunisian banking sector is stable, asset quality challenges are likely to increase during 2011. The agency assigns only Support Ratings to the major Tunisian banks Societe Tunisienne de Banque (STB; ‘3’), Banque Nationale Agricole (BNA; ‘3’), Banque de l’Habitat (BH; ‘3’), Banque Internationale Arabe de Tunisie (BIAT; ‘3’) and Amen Bank (AB; ‘3′), which are unlikely to change in the short term. The ratings are driven by the expectation of state support, if needed.
Fitch expects the major Tunisian banks’ overall performance to come under pressure in 2011 due to the country’s anticipated economic slowdown, and sizeable exposures to corporate or individual obligors with links to the previous ruling authorities.
Improving operating revenues is likely to prove challenging, as lending growth prospects are likely to be limited in 2011, given the expected muted demand for credit, in addition to reduced credit-risk appetite from banks.
Asset quality will remain the banks’ weakness in 2011. In addition to possible broad credit quality deterioration within the corporate sector, major Tunisian banks will have to manage their problematic exposures to corporate obligors linked to the ex-ruling authorities. Fitch has calculated that these exposures could account for at least 67% of the banks’ 2010 equity. Of the total exposure, the banks declared only 22% as impaired.
For details see Major Tunisian Banks: Annual Review and Outlook
Standard & Poor’s Ratings Services said today that its ratings on Prudential Financial Inc. (A/Stable/A-1;PRU) and its U.S. insurance operating companies are unaffected by our revision of the outlook on Japan to negative earlier today (see Outlook On Japan Sovereign Credit Rating Revised To Negative; Ratings Affirmed At ‘AA-/A-1+’). Insurer financial strength ratings explicitly incorporate the potential for direct sovereign risks–such as mandated changes in the terms of insurance obligations and currency controls–as well as significant investments in government bonds.
We don’t believe that PRU and its U.S. insurance operating companies are exposed to direct sovereign intervention risks associated with Japan.
Although investments in Japanese government and government agency securities accounted for about 20% of the financial services businesses’ general account investments as of Dec. 31, 2010, we believe that Japan-domiciled companies hold almost all of these instruments and that the U.S. insurance operating companies do not have any material holdings.
Bulletin: Prudential Financial Inc. And U.S. Operating Companies Ratings Unaffected By Revision Of Japan Outlook To Negative
Standard & Poor’s has revised the outlook to negative for a number of Japanese banks, insurers and power companies, plus several public institutions and local governments after it revised the country’s sovereign rating outlook to negative.
- Standard & Poor’s expects costs related to the March 11, 2011,earthquake, tsunami, and nuclear power plant disaster will increase Japan’s fiscal deficits above prior estimates by a cumulative 3.7% of GDP through 2013.
- We revised the outlook on the long-term rating on Japan to negative to reflect the potential for a downgrade if fiscal deterioration materially exceeds these estimates in the absence of greater fiscal consolidation.
- We affirmed our long- and short-term sovereign credit ratings on Japan at ‘AA-’ and ‘A-1+’, respectively.
The negative outlook signals that a downgrade is possible if Japan’s public finances weaken further over the next two years in the absence of fiscal consolidation to offset them. We believe that uncertainty over the country’s fiscal and economic outlook will lessen over the next six to 24 months.
If the government’s debt trajectory remains on its current course or begins to erode the nation’s external position, the long- and short-term ratings could be lowered.
If reconstruction costs place less burden on public finances than we expect–either because of lower outlays or increased revenues to cover them–and the government makes progress in strengthening Japan’s fiscal profile, we could revise the outlook back to stable.
For details see Research Update: Outlook On Japan Sovereign Credit Rating Revised To Negative; Ratings Affirmed At ‘AA-/A-1+’
Outlooks Revised To Negative On Six Japanese Public Institutions
S&P revised to negative from stable the outlooks on the long-term issuer credit ratings on Japan Finance Corp. (JFC), Japan International Cooperation Agency (JICA), Japan Expressway Holding and Debt Repayment Agency (JEHDRA), Japan Housing Finance Agency (JHF), Japan Finance Organization for Municipalities (JFM), and Narita International Airport (NAA).
Outlooks On Three Japanese Local And Regional Governments Revised To Negative
Outlooks On Japan’s Okinawa EPCO, Tokyo Gas, And Osaka Gas Revised To Negative
Outlooks On Shizuoka Bank And Seven Bank To Negative; JPMorgan Securities Affirmed
Outlook On Japan’s Deposit Insurance Corp. Revised To Negative
Outlooks On Eight Japanese Insurers Revised To Negative
The U.S. pharmacy services market remained stable during the fourth quarter of 2010 with further consolidation and growth expected in 2011, according to a new report by Fitch Ratings.
Aggregate volume increased 4.1% over the same period last year, with pharmacy benefit managers (PBMs) demonstrating stronger dispensing trends than retail drugstores during the quarter.
Fitch believes the fairly reliable demand characteristics of the prescription market remain intact during 2011. Fitch expects the market to generate mid single-digit organic prescription growth during 2011, assuming current economic conditions persist and the group continues to garner share at the expense of smaller and weaker players. Industry volume should grow at low- to mid-single-digit rates.
Consolidation drove many of the M&A transactions within the pharmacy services market during 4Q’10, and Fitch expects this trend to continue through 2011.
Fitch believes that companies with PBM operations, which are not part of their strategic core and lack significant scale, will continue to assess the value of operating a PBM.
Fitch’s U.S. Quarterly Prescription Tracker provides a quarterly review of selected data of the U.S. prescription drug market.
High energy prices are helping some energy-related sectors but have not yet posed a significant general threat to other industries, says Moody’s.
Moody’s global industry sector outlooks continued to shift slightly positively but were stable overall in the first quarter, according to Moody’s quarterly outlook review. The trend points to slowly improving conditions for corporate sectors globally.
“Naturally, high energy prices have imposed new conditions on numerous industries that are affected directly by these costs,” says Mark Gray, Moody’s Managing Director. “But so far, no particular industry has suffered high energy prices enough to warrant negative changes in their outlooks over the next 12-18 months.”
During the first quarter, none of Moody’s 63 industry outlooks moved in a negative direction, but the pace of positive movement was slow. Two sectors that saw shifts from stable to positive outlooks were energy related. High oil prices have helped the refining and marketing sector, while low natural gas prices have reduced some input costs for the chemicals sector, which also saw its outlook change to positive.
The outlook for the consumer durables sector also changed to positive from stable during the quarter, thanks to its heavy US focus and the gradual return of discretionary spending. The European and Middle Eastern building materials sector shifted from negative to stable, suggesting some relief to Europe’s ailing residential construction market.
The positive movement among outlooks has continued into the second quarter, with Moody’s raising the outlooks on life sciences, exploration and production, and integrated energy sectors so far in April.
The Moody’s global industry sector outlooks reflect the rating agency’s expectations for fundamental credit conditions in the industry over the next 12 to 18 months.
For details, see Global Industry Sector Outlooks: Worldwide Stability Leans Mildly Positive as Spending Returns and Oil Prices Soar.($550.00)
Production cuts and parts shortages caused by the Japanese earthquake and tsunami have led Standard & Poor’s to revise the credit outlook on Japan’s three largest automakers and three parts suppliers from Stable to Negative.
Japanese automakers and suppliers are likely to see deteriorated operating and financial performance in fiscal 2011 due to significant production cuts resulting from parts shortages following the March 11 earthquake.
S&P revised the outlooks to negative on Toyota Motor Corp., Honda Motor Co. Ltd., Nissan Motor Co. Ltd., Aisin Seiki Co. Ltd., Denso Corp., and Toyota Industries Corp. The outlook revisions also reflect our opinion that extended production cuts may erode Japanese automakers’ market shares and competitive positions in the longer term.
At the same time, we affirmed our ratings on the entities based on our view that anticipated deterioration in performance is unlikely to be as serious as in fiscal 2008 (ended March 31, 2009) and that significant deterioration in financial profiles is unlikely given a lower likelihood of negative free cash flow and the strong financial profiles and liquidity of most of the rated automakers. We also affirmed our ratings on Mitsubishi Motors Corp., the outlook on which was already negative.
Supply chain disruptions are posing a greater challenge for Japanese automakers than Standard & Poor’s initially anticipated, and have forced virtually all Japanese automakers to significantly cut output in Japan. The impact is also starting to spread to production outside Japan. At most Japanese automakers, overall domestic and overseas output is currently at about 50% of initial production plans.
For the full report, see Outlooks Revised To Negative On Six Japanese Automakers And Suppliers; Ratings Affirmed ($100.00)