Modern Debt Management

Over the last few years, the size and complexity of issuers’ debt and derivatives portfolios have increased, sometimes dramatically. In addition to the tactical use of SIFMA and LIBOR structures to minimize expected capital costs, issuers have taken selective exposure to SIFMA/LIBOR ratios as an isolated risk class. More recently, the industry has even seen Constant Maturity Swap (CMS) structures executed in order to take advantage of perceived anomalies in recent market yield curves. Given this environment, the historic use of “fixed/floating” mix has become an ineffective benchmark for capturing the rich variety of cash flow exposures and structures employed within debt portfolios today.

All of this translates to an acute industry need for a powerful, clear, and consistent framework for managing the risks associated with debt. From this need came the conception of Modern Debt Management (MDM). In many ways, the MDM approach is an extension of ideas that have been practiced by the investment management community for decades. Each component of an active debt management program has a direct corollary to traditional investment management.

The MDM process allows us to take any type of market-driven cash flow risk and boil it down to a clearly interpreted risk measure such as CFaR. With the availability of MDM, it no longer makes sense to analyze questions of floating rate exposure and basis risk separately. In order to truly understand the holistic nature of these risks in a portfolio, their interrelation must be understood through the use of a consistent quantitative framework. SCM is the only advisor in the country who can bring this valuable decision-making framework to the client.

Objectives

The objectives of Modern Debt Management include:

  • Reducing the cost of capital
    • Consolidate and understand on a portfolio level
    • Explore ways to optimize cost of capital within stated risk parameters
  • Managing risk to an acceptable level
    • Measure Cash Flow at Risk and average dollar volatility (initial and ongoing) (see "Risk Measures" below)
    • Calibrate portfolio risk to organizational tolerance juxtaposed with cost
  • Balancing the trade-of between cost of capital and risk
    • Evaluate products to achieve the most effective risk/return trade-off
    • Consider impact of various market conditions and shocks on projected risk/return paramaters
  • Establishing a rigorous analytical framework for evaluating new opportunities.

Process

The MDM process is as follows:

  • In close coordination with the client, develop the factors and model inputs needed to generate cash flows from the client’s debt and derivatives portfolio;
  • Model all debt and derivatives positions in the client’s existing portfolio;
  • After providing an initial analysis to the client, develop metrics for capital cost and risk that the client will then use in making tactical and strategic debt management decisions on an ongoing basis;
  • If the client chooses, SCM will help establish consistent guidelines, parameters, and risk budgets to be used in debt/derivative policies and when evaluating any potential change to the portfolio;
  • Evaluate proposals based upon their marginal contribution to the client’s selected cost and risk measures as defined above;
  • Based upon market conditions, recommend restructuring or new structure opportunities;
  • Coordinate and help execute new transactions; and
  • Provide periodic reports indicating where market movements may have an impact on cost or risk measures.

SCM works closely with the client to create meaningful inputs to the models. Clients can also input assumptions to create scenarios right from their own desktops.

Risk Measures

Cash Flow at Risk is defined as the maximum increase in cost that could be experienced due to the impact of market risk over a particular period of time and selected confidence level (a two standard deviation event). Budget/dollar volatility is defined as the average or expected increase in cost (a one standard deviation event).


Solutions

MDM applications can also help answer the questions clients face today with specific dollar numbers, based upon the client’s own unique view of the capital markets:

  • What sensitivity does my debt service schedule have to interest rates?
  • What are the hedging effects of our investments vis-à-vis debt?
  • How do we quantify the basis differential and risk on our SIFMA/LIBOR basis swaps?
  • How much floating rate debt should I issue to minimize Cash Flow at Risk (CFaR)?
  • How large a 6% cap should I use to keep CFaR under $25 million?
  • What is the “right” percentage of LIBOR to use to hedge tax-exempt VRDBs?

By using TargetRiskTM technology (patent-pending) embedded in SmartModels software from Intuitive Analytics, SCM can explicitly provide the answers to these questions and almost an infinite number of others, all depending upon the issues the client wants explored. SCM is the only advisor in the country who has invested in Smart Models analytics.

Outcomes

SCM understands the difficulty of balancing the variety of products in the market today. Our clients are faced with differing perspectives, systemic constraints, and the directive to achieve the lowest borrowing costs without undue risk. With MDM, issuers can cut through the confusion and quantify previously qualitative risks to develop an efficient debt and derivatives portfolio matching their organization's objectives.