The Treasury That Hedged the Wrong Benchmark
A mid-sized industrial borrower has a $250 million term loan priced at SOFR + 175 bps, resetting quarterly, maturing in 4 years. In January, the treasurer, expecting rates to rise, entered a 3-year pay-fixed SOFR swap at 4.10% with a notional of $250 million, amortizing to match scheduled principal. By September, the company drew an additional $80 million revolver that is priced off a different benchmark (1-month Term SOFR compiled by a different administrator) and concurrently prepaid $40 million of the term loan after an asset sale. The treasurer reports to the board that the hedge is 'fully effective' because notional roughly matches debt. The CFO notes that the swap's mark-to-market is now negative $6.2 million and asks whether the hedge is still doing its job. The company applies hedge accounting under ASC 815 and must report effectiveness quarterly.
1. Evaluate whether the treasurer's 'fully effective' claim is defensible. What specific sources of ineffectiveness exist given the facts?
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The claim is not defensible on the facts. At least four distinct sources of ineffectiveness exist:
- Notional mismatch after the prepayment. The swap amortization schedule was set to the original term loan. Prepaying $40M means hedged principal is now lower than swap notional for the remaining life - the company is over-hedged and carries a speculative (non-hedging) position on the excess.
- Benchmark basis. The revolver prices off 1-month Term SOFR from a different administrator than the swap's reference. Even if both track 'SOFR', the tenors and fixing conventions differ, creating basis risk that is not captured by a notional comparison.
- Different instrument hedged. The swap was designated against the term loan, not the revolver. The $80M revolver draw is unhedged unless explicitly designated, so 'notional ≈ debt' masks that a new exposure exists.
- Timing/designation. The prepayment and draw are designation-affecting events; if the hedge relationship was not re-designated and re-documented, prospective effectiveness testing is measuring the wrong exposure.
A dollar-offset or regression test run on the actual hedged item (post-prepayment, post-draw) would likely show ineffectiveness well beyond the 80–125% corridor. The treasurer is conflating 'similar size' with 'effective'.
2. The CFO wants to know what to do before the next quarterly close. Recommend the sequence of actions and the accounting consequences.
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Recommended sequence:
- Re-measure the hedged item. Recalculate the expected SOFR-based cash flows on the current term loan balance and separately identify the revolver exposure. Do not test against the old schedule.
- De-designate and re-designate. Formally de-designate the existing relationship as of the event date, document the prepayment and draw, and re-designate a new relationship with a revised notional schedule. Any ineffectiveness accumulated up to de-designation is measured and recognized in earnings.
- Deal with the over-hedge. The $40M of swap notional no longer tied to a hedged item must be either (a) terminated/partially unwound, or (b) explicitly treated as a derivative not in a hedging relationship, marked through earnings. It cannot remain in the effective hedge.
- Address the revolver separately. Decide whether to designate a portion of the swap (or a new hedge) against the revolver, accepting the basis risk, or leave it unhedged and disclose.
- Effectiveness testing. Run prospective and retrospective tests on the revised relationship. If the regression or dollar-offset test fails the corridor, hedge accounting for that period is discontinued and the swap is marked to earnings.
- Disclose. The $6.2M negative MTM, the de-designation, and the over-hedge should be disclosed as they affect reported results and risk profile.