Jim Colby DATA-DRIVEN APPROACH TO May 15, 2016 · PDF filedata-driven approach to low-cost...

DATA-DRIVEN APPROACH TO

LOW-COST FUNDING Jim Colby

May 15, 2016

© 2015 by Honeywell International Inc. All rights reserved.

1

Integration and Planning Underway

DISCUSSION TOPICS

• Desired Debt and Interest-Rate Portfolio

• Tactical and Timing Considerations

• Conclusions

• Q&A


2

Debt Influences Cash Flow, WACC and Firm Value

EQUITY VALUATION THEORY

• Cash Flow and Cost of Capital Drive Stock Valuation

Valuefirm = FCFt

(1 + WACC)t or

FCF1

(WACC - g) t =1

t=n

Valueequity = Valuefirm - Valuenet debt

FCFfirm: Free cash flow (before interest, but after taxes)

WACC: Weighted average cost of capital

g: Long-term average FCF growth rate


3

Diversifying Funding Currency Can Be Beneficial

BENEFITS OF FINANCING IN FOREIGN CURRENCIES

• Reduces Impact of Currencies on

Valuation

• Diversifies Investor Base,

Enhancing Liquidity

• Reduces Earnings Translation

Risk

• Reduces CTA Volatility

• Potentially Lower Interest Rates

($ Mil.) USD EUR in USD Total USD USD EUR in USD Total USD $ %

FCF1 1,000 1,000 1,200 2,200 1,000 1,000 1,000 2,000 (200) (9.1%)

Enterprise Value 44,898 40,816 (4,082) (9.1%)

Net Debt 6,000 - - 6,000 6,000 - - 6,000 - 0.0%

Equity Value 38,898 34,816 (4,082) (10.5%)

WACC 8% 8.0%

g 3.1% 3.1%

EUR/USD FX Rate 1.2000 1.0000

Enterprise Value 44,898 40,816 (4,082) (9.1%)

Debt - 5,000 6,000 6,000 - 5,000 5,000 5,000 (1,000) (16.7%)

Equity Value 38,898 35,816 (3,082) (7.9%)

Fictitious Example Showing Impact Of Foreign Debt On Valuation

EUR Businesses ChangeEUR Businesses


$400

$900

$900 $800

$300 $216 $51

$550 $600 $600

2016 2017 2018 2019 2020 2021 2022 2023 2027 2028 2033 2034 2035 2036 2037 2041

US CP US Bonds Eurobonds Euro CP

$750

$2.8B

Debt Portfolio Diversified by Maturity and Currency

Debt Maturity Profile At March 31, 2016

4

$3.6B

$1.1B

$2.0B

$1.4B

$1.7B

($M, Eurobonds Shown as

USD-Equivalent)

$1.1B

$850

$1.0B

Backed by Committed Credit Facilities

Of $5.5B ($4.0B 5-Yr/$1.5B 364-Day)


5

Liquidity and Interest Rate Decisions Are Separate

BIFURCATING LIQUIDITY FROM INTEREST RATE RISK

(0.50)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

3 Months 2 Years 5 Years 10 Years 30 Years

Cost of Liquity and Interest Rate Certainty in USD

Interest Rate Spread Vs Libor

Cost of Interest

Rate Certainty

Cost of

Liquidity

Cost of Interest Rate Certainty1 'A' Bond minus Swap Rate (Last 10-year)

Tenor 3m 3Y 5Y 10Y 30Y

Current 13.0 55.0 78.8 120.1 174.6

Percentile 55% 46% 45% 46% 61%

Average 23.5 79.5 97.4 134.8 166.9

Max 500.0 364.2 376.8 424.8 489.6

Min -12.2 8.4 14.4 28.9 46.4

Cost of Liquidity1

Interest Rate

Certainty

(0.40)

(0.20)

-

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

3 Months 2 Years 5 Years 10 Years

Cost of Liquity and Interest Rate Certainty in EUR

Interest Rate Spread Vs Libor

Cost of

Liquidity

1 Source: Bloomberg, HSBC, Honeywell


6

Segregate By Currency And Explicitly Consider Cash

HOW DO WE CALCULATE FLOATING RATE

EXPOSURE?

• Segregate By Major Currency

- Correlations Between Interest Rates In Different Currencies Uncertain

• Net Floating Rate Exposure

- Short-Term Debt + FRNs + Fixed Debt Swapped To Floating – Floating

Rate Debt Swapped to Fixed + Current Maturities Of Long-Term Debt

• Net Debt

- Total Debt - Cash


7

Floating Rates Historically Cheaper, But Rates Are Historically Low

FLOATING RATES HAVE OUTPERFORMED HISTORICALLY

• Realized Floating Rate Performance (Grey) And Projected Floating Rate Performance

(Blue) Versus Fixed Rates (Red)

• Treasury Yields (T-Bills) From 1962 - October 1988 And Swap Rates (Libor) Thereafter

Source: Bloomberg, Mizuho


8

Forward Rates Never Incorporate Interest Rate Downturns

SWAP PERFORMANCE IN PREVIOUS HIKING CYCLES

Source: Bloomberg, Barclay’s, Honeywell


9

Trade-Off Between Interest Expense and Interest Rate Risk

TRADE-OFF BETWEEN FIXED AND FLOATING RATE RISK

Considerations

• Cash Balances

• Pension Liabilities

• Cash Flow/Earnings Cyclicality

• Savings Today Vs Costs

Tomorrow

• Credit Rating and Leverage

• Risk Tolerance

• Forecasting Ability

Source: Barclay’s, Honeywell


10

Cost of Waiting Can Be Compared to Interest Rate View

THE COST OF WAITING

10-Year Cost of Waiting 5-Year Cost of Waiting

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

5Y 4Y 3Y 2Y 1Y

Current Swap Rate Forward Swap Rate

0.0%

0.3%

0.5%

0.8%

1.0%

1.3%

1.5%

1.8%

2.0%

2.3%

2.5%

10Y 9Y 8Y 7Y 6Y 5Y 4Y 3Y 2Y 1Y

Current Swap Rate Forward Swap Rate

5-Year

Wait Period Spot Rate Fwd Rate (Breakeven) Distance to Breakeven

1-Year Wait 1.05% 1.25% 20 bps

2-Year Wait 0.95% 1.35% 40 bps

3-Year Wait 0.85% 1.45% 61 bps

4-Year Wait 0.74% 1.56% 82 bps

10-Year

Wait Period Spot Rate Fwd Rate (Breakeven) Distance to Breakeven

1-Year Wait 1.51% 1.69% 17 bps

2-Year Wait 1.44% 1.78% 34 bps

3-Year Wait 1.35% 1.88% 53 bps

4-Year Wait 1.25% 1.97% 72 bps

5-Year Wait 1.15% 2.06% 91 bps

6-Year Wait 1.05% 2.13% 108 bps

7-Year Wait 0.95% 2.19% 125 bps

8-Year Wait 0.85% 2.22% 137 bps

9-Year Wait 0.74% 2.31% 157 bps

Source: Bloomberg, Mizuho


11

Interest Rates are At Historic Lows – Where Do They Go Next?

INTEREST RATE TRENDS

Source: Bloomberg


12

Consider Breaking Yield Curve Into Components

INTEREST RATE EXPECTATIONS

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

LIBOR

Driven by expectations for Fed policy

Driven by expectations for longer term economic environment

Considerations

• Direct and Indirect China

Concerns

• Brexit Risk

• Uncertainty About Changes In

Monetary Policy Transmission

Mechanism

• U.S. Inflation

• U.S. Growth

Considerations

• Inflation Expectation

• Real Interest Rate

Expectations

• Savings Vs Investment Trends

• Foreign Interest Rates

• Short-Term Rate Expectations


13

How Fast Can Rates Increase And How High Can They Really Go?

FACTORS INFLUENCING SHORT-TERM RATE VIEW

Source: SocGen

• Direct and Indirect China Concerns and Brexit Risk Delay Fed Hike

• Election in Fall

• Low Inflation Provides Excuse to Wait

• Late in Cycle (See Below)


15

Can Model Assumptions About Factors Influencing ST and LT Rates

YIELD CURVE SEGMENTATION APPROACH

Expected number of Fed hikes in 2016 1 UST Model Current Market Difference

Expected number of Fed hikes in 2017 2 2s 0.94 0.71 (0.23)

Peak Fed fund rate in this cycle (reached in 5y) 1.5 5s 1.48 1.20 (0.28)

Long run real Fed funds rate (10y forward 20y) 1 10s 1.67 1.76 0.08

Long run inflation expectation (PCE, 10y forward 20y) 2 30s 2.79 2.62 (0.17)

Inputs Output (%)

Source: BofA, Honeywell


16

Foreign Rates Have Had Major Influence On 10-Year UST Since 2001

REGRESSION ANALYSIS APPROACH

Regression Statistics

Multiple R 0.866035336

R Square 0.750017204

Adjusted R Square 0.735867234

Standard Error 0.005528186

Observations 57

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

Intercept 0.016536165 0.002069372 7.990912 0.00000 0.012385531 0.020686799 0.012385531 0.020686799

1y Forward CPI Rate 0.079141112 0.053198027 1.48767 0.14276 -0.027560618 0.185842842 -0.027560618 0.185842842

3mL 0.111195956 0.060950359 1.824369 0.07374 -0.011054984 0.233446895 -0.011054984 0.233446895

GLB Bond Yield 0.606446139 0.09880552 6.137776 0.00000 0.408267363 0.804624916 0.408267363 0.804624916

Sources: GS internal as of 4-May-2016. Past performance is not indicative of future results. Backtesting analysis/simulated results are for illustrative purposes only. GS provides no assurance or guarantee that the strategy will operate or would have operated in the past in a manner consistent with the above backtesting analysis. Backtested and/or past performance figures are not a reliable indicator of future results.

• Foreign Interest Rates Biggest

Driver According to Regression

• 3M Libor Has Some Influence

• CPI Expectations Insignificant

• Model’s Projection Driven By

Bank Forecast of Foreign Rates


17

Swap Spreads Have Turned Negative – Will They Revert?

SWAP SPREADS

Recent Swap Spread Drivers

• Central Bank Selling USD Reserves To Support Local Currencies

• Fixed Debt Swapped To Floating More Offsetting Interest In Swapping To Fixed

• Regulatory Impact – Limitations On Proprietary Trading To Exploit Market Anomalies

• Reduced Derivatives Risk Premiums In Cleared Market – Should Swaps Trade As A

Credit Spread Above Treasuries As Much As Before?


18

More Complicated Now

SWAP PRICING CONSIDERATIONS

• Roll-Out Of Regulations Globally Has Resulted In Big Pricing

Discrepancies Among Banks (CVA, FVA, LCH IM, Market Risk,

ROIC)

• Long-Term Swaps May Need to Be Collateralized And Will Be

Expensive If They Are Not

• Consider Funding Costs Of Counterparty

• May Want To Syndicate Swap

• Need To Comply With Dodd-Frank Requirements


19

Every Company’s Situation Is Unique

CONCLUSIONS

• Determine Optimal Debt And Interest-Rate Portfolio

- Currency Composition

- Debt Maturity Profile

- Cost Of Liquidity Versus Cost Of Interest Rate Certainty

- Quantify Trade-Offs Between Fixed And Floating Rate Debt

• Develop Tactical Plan To Migrate From Current Portfolio To

Desired Portfolio

- Model Assumptions (Segment Yield Curve, Regression Analysis, Fed,

Real Interest Rates, Inflation Expectations, Swap Spreads)

- Factor In Cost Of Waiting

Jim Colby DATA-DRIVEN APPROACH TO May 15, 2016 · PDF filedata-driven approach to low-cost...

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