Tuesday, January 26, 2010

Jarden Compares Loan and Bond Costs

Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam.  On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012.  Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities.  Over the next 7 months, it completed two transactions.

August 2009: "Amend and Extend"
  • In August 2009, the company extended the maturity of $600 million of Term B loans ("TLBs") from January 2012 to January 2015 through the creation of a "Term B4" tranche.  This new tranche was priced at LIBOR + 3.25%.  The remaining $724 million of term loans remain due through 2012.
  • Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.
January 2010: Senior Subordinated Notes
  • In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020.  The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
  • The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
  • The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.
So which is cheaper?
With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond's effective cost is 7.625%.  So the loan is a cheaper source of capital than the bond?  Not so fast!  The loan is floating rate - if LIBOR goes up, the company's interest cost will go up with it.  The bond is fixed rate - no matter what happens to interest rates, the coupon on the bond will not change.  So we cannot just compare the current loan cost of 3.5% to the bond's cost of 7.625% - that would be comparing apples to oranges.

Combining a Loan and a Swap
In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate.  This is done using an interest rate swap.  Let's swap the loan to a fixed rate, as follows:
  • Step 1: The company borrows at LIBOR + 325 basis points.
  • Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.  
  • The current quote for such an interest rate swap is about T+10: 
    • The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
    • The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract. 
  • These transactions can be expressed as follows:
We can now calculate the effective fixed rate cost of the loan-swap combination:
  • Payment to loan holders:          LIBOR+325 basis points
  • Received from the swap bank:   LIBOR
  • Payment to swap bank:            Treasury +10 basis points
The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders.  The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335.  The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.

The Loan is Cheaper
The effective cost of the bond is 7.625% while the effective cost of the loan is 7.125%, so the loan is cheaper by 0.50%, or 50 basis points.

Why is the bond more expensive?  And why would the company issue the bond if it is more expensive than the loan?  Watch the blog for answers to these questions.


Anonymous said...

50 bps isn't much when compared to the flexibility of a bond (few/no covenants) and reduction of amendment fees etc.

Anonymous said...

I agree. This is an easy decision for Jarden - take the long-term money with few covenants, even if it costs a bit more.