In an effort to minimise its interest expense and apply risk limits on future earnings per share (EPS) volatility, Honeywell developed and executed a strategy to manage the interest rate risk on its $7.6 billion debt. By analysing historical rate cycles for the past 60 years, Honeywell found that the forward LIBOR curve usually erroneously predicts the entire future rate cycle by under-estimating the initial Federal Reserve tightening cycle and ignoring the next downturn. Evaluating savings achieved through different tenors of swapped fixed rate debt, Honeywell found that since 1980, ten year swaps had generated net present value (NPV) positive savings 100% of the time.

“Admittedly, this was during a long-term period of declining rates; therefore, Honeywell observed swap performances during rising rate environments from 1950 through 1980, as well. Swap performances still resulted in positive NPV savings, as long as the swaps were not entered into immediately before rates began to rise,” says Andrea Vasilevski, a senior analyst in the corporate finance department.

Honeywell’s objective was to develop a strategic approach to swapping current fixed rate debt by determining the optimal amount, timing, and maturity of debt to swap, while applying established limits to floating rate exposure to manage rate volatility on EPS for current and future years.

Honeywell’s proposed floating rate net debt target was compared to its peer group to ensure that it wasn’t exposed to larger floating rate exposure than tolerated by investors. The company found that its current floating rate exposure of 13% was within the peer group range of 0% to 55%. This is a low floating percentage, but not unusual at the trough of the interest rate cycle.

Once Honeywell determined that floating rate exposure should not exceed 55%, it decided the best tenors to swap to floating. This was done in part by assessing which debt maturity had the highest initial carry based upon current rates. Additionally, each debt maturity was analysed to determine which one had the highest NPV through a breakeven analysis that incorporated different scenarios regarding timing of the Fed’s rate actions. The scenarios included current market sentiment as well as the past two major interest rate cycles in 1994 and 2004.

Honeywell found that the optimal debt maturity to swap to floating was the Q1 2011 ten-year note planned for issuance. The ten-year note was targeted because Honeywell observed that all ten-year swap transactions since 1980 resulted in positive NPV savings.

Rates were unlikely to rise in the near future and a return to the interest rate tightening environment of the 1970’s and 1980’s was improbable. Furthermore, a ten-year swap was expected to benefit from a decline in interest rates in the next interest rate cycle in the latter years of the swap. Forward curves are unusual in that they are typically continuously upward sloping and do not build in subsequent rate cycles. Shorter-term swaps could likely mature before the next rate cycle and not reap the benefits.

“By performing detailed scenario analyses, Honeywell developed a rational and methodical approach understood by senior management to enter into floating rate swaps if current market conditions are present and risk limits are not jeopardised. This approach has enabled Honeywell to save an estimated $36m of interest expense in 2011 and approximately $80m over the past five years,” said Andrea.