Separately from overall debt capacity, debt structure reflects specific choice of capital structure instruments.  We address the goal of maximizing shareholder value in two ways:

• In good times, minimize the expected funding costs of the firm
• In bad times, minimize the costs of financial distress

In this post we consider duration matching, which clients occasionally propose.

Immunization

In portfolio management, immunization seeks to eliminate exposure to interest rate risk.  Duration matching achieves this goal temporarily and for parallel shifts in the yield curve.  Hull describes its use for financial institutions.  Should non-financial corporates use this principle to inform their debt structure decisions?

Avoid Duration Matching for Corporates

The answer to the previous question, in most cases, is No.  Here’s why.

Corporates face little interest rate risk.  There are many risks for corporates that dominate interest rate exposure.  Let’s look, for example, at P&G’s historical operating results:

Note two important characteristics:  The interest expense volatility is smaller than that of EBITDA, and the absolute level of IE (and thus of absolute risk contribution) is lower as well.

This finding is generally true across most investment-grade corporate (non-financial) firms.  Even for spec grade firms, where increased leverage brings the EBITDA and IE lines closer, we find that interest rate movements contribute little to overall earnings volatility.

Duration matching presupposes remarking asset values.  Fund managers use immunization techniques to stabilize portfolio returns, where “return” includes changes in the fair market value of the underlying assets.  For high-grade fixed-income assets, the dominant value risk is indeed yield curve changes.  Corporate assets (and liabilities) are, unlike held-for-sale assets, not continually remarked to fair market value.

Financial institutions seek immunization for two reasons.  First, particularly for depository institutions, solvency is a primary focus.  Even if a firm is sufficiently liquid, regulatory constraints on solvency must be addressed.

Second, financial firms may see a large portion of their operating revenues and costs directly exposed to yield curve shifts.  The desire to stabilize net interest income suggests immunization strategies.

Non-financial firms generally do not share these characteristics.

Asset duration is poorly understood.  Damodaran (see e.g. p. 31ff here) extends the the calculation of duration for fixed-income instruments to corporate projects.  He quickly points out a shortcoming of this approach:  unlike a bond, the cash flows of a corporate project are not known in advance, and in fact often exhibit a meaningful correlation with interest rate movements themselves.  He suggests instead a historical regression technique, but this technique relies on assumptions that may limit the suitability of this second approach.

Term debt costs more.  Yield curves usually exhibit a positive term premium (see e.g. here), suggesting that longer-duration debt costs more than floating-rate debt.  The realized cost differential has been north of 100bp over the past several decades.  Duration matching strategies must demonstrate a value to shareholders that outweighs this.

Duration matching ignores other risks.  The value of a automobile assembly plant, or a lease on a retail store mall, depends on many risk factors, including consumer sentiment, aggregate GDP changes, unemployment, changing tastes, and a host of others.  For the non-financial firm, interest rate risk, though it plays an important role in the denominator of DCF calculations, is well down the list of factors that most corporations consider when targeting liquidity or stable profits over time.

Summary:  Consider the Bigger Picture

While a focus on the rate used to discount future cash flows is mathematically convenient, it may not be the best lynchpin for design of a debt structure.  The choice of debt structure should reflect the spectrum of risks that a firm faces, as well as the variety of expected funding costs of different debt instruments.