Because all three of our companies operateinternationally, they pose high risk to interest rate fluctuations.
This isvery similar to what we saw in the previous section on exchange rate risk.AAPL Exposure to Interest Rate RiskAAPL’s 10K indicates that its exposure to changes ininterest rates primarily relates to its investment portfolio and outstandingdebt. That said, it also indicates that AAPL’s interest income and expense are bothvery much sensitive to fluctuations in U.S. interest rates. Changes in U.
S.interest rates will affect AAPL in a couple of ways: a) interest earned on AAPL’scash, cash equivalents and marketable securities, b) fair value of thosesecurities, as well as costs associated with hedging, and finally c) interestpaid on the AAPL’s debt. We can also find from the 10K that AAPL typicallyinvests in highly-rated securities, and the company’s investment policy limitsthe amount of credit exposure to any one issuer. Furthermore AAPL’s investmentpolicy requires all investments to be in investment grade, with the keyobjective of minimizing company’s risk of a potential principal loss.Figure5.1illustrates AAPL’s outstanding floating-rate and fixed-rate term debts as ofSeptember 2017 with varying maturities for an aggregate principal amountof $104 billion. The figure 5.2shows as of October, 2017(in billions), AAPL’s term debt and when the paymentsare due by AAPL.
AAPL’s credit rating1 fromStandard & Poor’s, Moody’s and Fitch group remains investment grade ashighlighted in figure 5.3. Which canalso be complimented by the Debt2-Equityratio AAPL maintains as shown in figure5.4. From the 10K we also gather that as of September, 2017 and September,2016, AAPL had outstanding floating-rate and fixed-rate notes with varyingmaturities for an aggregate carrying amount of $103.
7 billion and $78.9 billion,respectively. We also find that for AAPL a 100 basis point increase in marketinterest rates would cause interest expense on the AAPL’s debt as of September,2017 and September, 2016 to increase by $376 million and $271 millionrespectively.AAPL’s 10K shows that to manage interest rate risk itenters into interest-rate swaps, options, other financial instruments.
We knowinterest rate swaps allows effective conversion of fixed-rate payments intofloating-rate payments or floating-rate payments into fixed-rate payments. As aresult gains and losses on term debt are generally offset by the correspondinglosses and gains on the related hedging instrument. We also find that tomanage interest rate risk on the U.S. dollar-denominated fixed-rate notes AAPLentered into interest rate swaps which are highlighted in figure 5.
5. Furthermore the 10K also highlights that to manageforeign currency risk on AAPL’s foreign currency-denominated notes, theorganization has also entered into foreign currency swaps to effectively convertthese notes to U.S.
dollar-denominated notes as a measure to offset itsinterest rate risk.HPQ Exposure to Interest Rate RiskNow let’s look at the HPQ’s exposure to Interest RateRisk. HPQ’s 10K shows that the company is exposed to interest rate risk relatedto debt it issues and its investment portfolio. HPQ issues long-term debt ineither U.
S. dollars or foreign currencies based on market conditions at thetime of financing. The company’s aggregate future maturities of debt at facevalue, including capital lease obligations as of October, 2016, are shown in figure 5.6. From figure 5.7 we see that HPQ’s borrowings over the period is slowingdown which is a good sign, meaning it has sufficient resources to fuel itsbusiness.
Credit rating15 for HPQ remains at aninvestment grade level with moderate risk having a stable outlook. Thisinformation can also be complimented by the Debt-Equity ratio HPQ maintains asshown in figure 5.6. The company’s10K confirms that in the fiscal year 2016, debt-to equity ratio decreased by2.08x, primarily due to negative equity resulting from transfer of net assetsof $32.
5 billion to Hewlett Packard Enterprise and redemption of $2.1 billionof fixed-rate U.S.
dollar global notes due to the separation.Form the company’s 10K we see that to modify themarket risk exposures in connection with the debt and to achieve U.S.
dollarLIBOR3-basedfloating interest expense, HPQ engages in interest rate and currency swaps. The10K also makes us aware that in order to hedge the fair value of certain fixed-rateinvestments, HPQ enters into interest rate swaps that convert fixed interestreturns into variable interest returns. HPQ also uses cash flow hedges to hedgethe variability of LIBOR-based interest income received on certainvariable-rate investments and it further enters into interest rate swaps thatconvert variable rate interest returns into fixed-rate interest returns.
From the 10K we further learn that HPQ utilizesderivative contracts to offset the company’s exposure to interest rate risk.Such derivative contracts do involve the risk from its counterparty’s non-performance,which at times may further result in a loss. However the company estimates thelikelihood of this happening is very remote. HPQ uses derivative instruments,primarily forwards, swaps, and options, to hedge certain interest rateexposures. The derivative value of the Interest Rate contracts for periodsOctober 2016 and October 2015 are $48 million and $58million respectively.Lenovo Exposure to Interest Rate RiskLastly we take a look at Lenovo’s exposure to InterestRate Risk.
From the company’s annual report we find that like AAPL and HPQ,Lenovo’s interest rate risk also arises from short-term and long-termborrowings denominated in United States dollar. In figure 5.9 we see Lenovo’s short-term and long-term borrowingsdenominated in United States dollar.
The company’s exposure to all borrowingsto interest rate changes can be seen in figure5.10. As we have found for Lenovo’s other risk exposures itis the company’s ERM’s responsibility to define strategies to offset theinterest rate risk, through the use of appropriate interest rate hedginginstruments. From the company’s annual report we learn that Lenovo manages itscash flow interest rate risk by using floating-to-fixed interest rate swaps.This is also very similar to what we have seen being followed in our other twocompanies. For the interest rate swap, Lenovo agrees with other parties toexchange, at specified intervals (typically quarterly), the difference betweenfixed contract rates and floating-rate interest amounts calculated by referenceto the agreed notional amounts.
Analyzing Approaches on Interest Rate RiskIn all three of our companies we find that the mostpopular way they plan to offset the Interest Rate Risk exposure if to make useof common derivative instruments or to use the approach of interest rate swap.As we have not seen any usage of any specialized derivative we would like toalso recommend that in addition to their existing strategies to manage InterestRate Risk exposure, Interest Rate Collar (derivative instrument) can also belooked into. An interest rate collar is actually an investmentstrategy that uses derivatives to hedge an investor’s exposure to interest ratefluctuations. An Interest Rate Collar sets a maximum (which is termed as cap)and minimum (which is termed as floor) boundary on a given floating rate (suchas LIBOR or Prime).
If the floating rate rises above the maximum or cap level,the company is credited for the difference. If the floating rate falls belowthe minimum or floor level, the company is debited for the difference. Lastlyone of the alternate alternative methods for companies to mitigate theirexposure is to issue bonds to raise capital. This is something AAPL in November20174.
Thecompany issued $7 billion of debt in latest fund raising for $300 billionshareholder program. AAPL had repeatedly borrowed in the corporate bond marketto reward its shareholders, rather than repatriate some of the $252.3 billionin cash. Proceeds of the deal will be used for catchall ‘general corporatepurposes’ which includes share buybacks and dividend payments.We now explore the bond landscape and outlook for nearfuture, 2018. Figure 5.
11 shows thetrends in Government bonds, corporate bonds and Treasury bills. We see that thelong term treasure yield curve is flattening, signaling a) weaker economy or b)Fed raising rates too quickly. Mostly the outlook looks neutral for 2018.
As weknow Fed has already planned for three more quarter-point increases in 2018.This may hurt traditional bond prices, however investments with floating couponrates may benefit from future Fed rate hikes. High-grade investment-gradecorporate bonds, may remain a fair alternative to equities, which are veryexpensive now. Bond market is expecting fewer rate hikes, on the view thateconomy is growing too slowly and inflation is so low.
Figure 5.12 shows the typical impacts on increase in Fed rates. Wecan see that Fed funds rate and one-year Treasury rate track each other veryclosely, however the interest rate on a 10-year Treasury bond does not. So itis safe to conclude that the projected increase in fed funds rate for 2018 willsuccessfully raise short-term interest rates but have a limited impact onlong-term interest rates.1 Moody’s www.moodys.com, S www.standardandpoors.com, Fitch www.fitchratings.com2 Debt for thisratio is Debt minus Cash.3 LIBORwww.bankrate.com/rates/interest-rates/libor.aspx4Apple issues$7 billion of debtwww.marketwatch.com/story/apple-is-tapping-the-corporate-bond-market-with-a-deal-that-could-raise-7-billion-2017-11-06