Board of Governors of the Federal Reserve System

November 12, 2020

How the Federal Reserve's central bank swap lines have supported U.S. corporate borrowers in the leveraged loan market

Annie McCrone, Ralf Meisenzahl, Friederike Niepmann, and Tim Schmidt-Eisenlohr

The cost of borrowing U.S. dollars through foreign exchange (FX) swap markets increased significantly in the beginning of the COVID-19 pandemic in February 2020, indicated by larger deviations from Covered Interest Rate Parity (CIP).¹ CIP deviations narrowed again when the Federal Reserve expanded its swap lines to support U.S. dollar liquidity globally—by enhancing and extending its swap facility with foreign central banks and introducing the new temporary Foreign and International Monetary Authorities (FIMA) repurchase agreement facility.² Recent research by Meisenzahl, Niepmann, and Schmidt-Eisenlohr (2020) shows how wider CIP deviations result in higher borrowing costs for U.S. corporations in the leveraged loan market. In this note, we discuss this finding, which suggests that, besides other channels, the Federal Reserve's initiatives to provide global U.S. dollar liquidity contributed to easier financial conditions for U.S. corporate borrowers.

In this FEDS Note, we document how disturbances in foreign exchange markets related to the international cost of borrowing U.S. dollars affect U.S. corporate borrowers. International investors depend on foreign exchange markets when participating in the market for U.S. leveraged loans---large, non-investment grade loans originated by a syndicate of lenders. Using changes in the cost of borrowing dollars during the loan origination process, we show that U.S. corporate borrowers have to pay a higher interest rate if their loans are originated when international investors face a higher cost of borrowing U.S. dollars. Federal Reserve interventions that reduce the cost of borrowing U.S. dollars internationally through lending U.S. dollars to other central banks can therefore reduce interest rates paid by U.S. corporations.

The U.S. leveraged loan market is a $1.2 trillion market in which large, U.S. firms, typically with a credit rating below investment grade, obtain funding. Today, the funding for these loans comes primarily from nonbank investors. While banks act as the lead arrangers, they sell a large portion of the loans quickly to other investors, in particular to Collateralized Loan Obligations (CLOs, special purpose vehicles that invest in leveraged loans) and mutual funds. Figure 1, taken from Lee, Liu, and Stebunovs (forthcoming) shows a steady decline of the bank holdings (the red and dark orange portions of the bars) and a corresponding increase in nonbank holdings (all the other portions of the bars) of syndicated leveraged loans over the first month after origination.³

As also shown in figure 1, foreign banks only hold a small portion of leveraged loans directly. However, it appears that foreign bank and nonbank investors are significant participants in this market through holdings of CLOs and mutual funds. While comprehensive data are difficult to obtain, DeMarco, Liu, and Schmidt-Eisenlohr (2020) estimate that foreign investors hold about 20% of U.S. CLOs.

Figure 1. Lenders in leveraged loan syndications after origination

CIP deviations

Foreign investors often fund their investments in U.S. securities through the FX swap market. The relative cost of borrowing U.S. dollars through the FX swap market is reflected in the cross-currency basis. The cross-currency basis is defined as the difference between the cost of borrowing U.S. dollars in the cash market directly and the cost of borrowing U.S. dollars indirectly by first borrowing in foreign currency and then swapping the foreign currency into U.S. dollars today and back into foreign currency in the future at a price fixed today. Expressed mathematically, the cross-currency basis corresponds to the x_t in the following equation:

$$$$ (1+y^{\$}_t) = (1+y^{\ast}_t + x_t) S_t/F_t, $$$$

where $$(1 + y^{\$}_t)$$ is the cost of borrowing U.S. dollars directly and $$(1 + y^{\ast}_t)$$ is the cost of borrowing foreign currency. $$(1 + y^{\ast}_t) S_t/F_t$$ reflects the cost of borrowing U.S. dollars by swapping foreign currency into U.S. dollars at the spot exchange rate $$S_t$$, and then swapping the U.S. dollars back into foreign currency in the future at the forward rate $$F_t$$.

A non-zero cross-currency basis implies the failure of Covered Interest Rate Parity (CIP).⁴ When the cross-currency basis is negative, it is cheaper to borrow U.S. dollars directly than to borrow U.S. dollars through the FX swap market. When the cross-currency basis becomes more negative, investments in U.S. securities become less attractive to foreigners without direct access to U.S. dollar funding because for given interest received in U.S. dollars, the actual return to the foreign investor shrinks amid higher funding costs.

Figure 2 displays CIP deviations (the dashed line), measured as the average five-year U.S. dollar Libor cross-currency basis against nine major currencies over time.⁵ Over the past decade, the average cross-currency basis widened significantly (became more negative) at times, most notably in late 2011 and early 2016, and again in February 2020 when the COVID-19 pandemic hit the world economy, as we discuss later.

As figure 2 shows, there is a close connection between CIP deviations and the share of newly originated leveraged loans purchased by mutual funds and CLOs. When CIP deviations become larger, reflected in a more negative average cross-currency basis, mutual funds and CLOs participate less, presumably because CLO and mutual fund investors find leveraged loans less attractive amid higher hedging/funding costs. When these investors pull away from the market, conditions for U.S. borrowers in the leveraged loan market deteriorate, as we show below using micro data.⁶

Figure 2. CIP deviations and mutual fund and CLO share in new leveraged loans

Leveraged loans become more expensive when CIP deviations widen

To identify the effect of CIP deviations on lending terms in the U.S. leveraged loan market, we follow the methodology in Meisenzahl, Niepmann, and Schmidt-Eisenlohr (2020). Specifically, we study price adjustment during the syndication process of leveraged loans based on data from the Standard & Poor's Leverage Loan Commentary and Data (LCD). These data provide detailed information on so-called flexes, adjustments to the loan terms over the syndication process, including when initial loan terms and final loan terms were fixed.⁷

Using this information, we relate the difference between the final interest rate spread and the initial interest rate spread of a leveraged loan to changes in CIP deviations over the syndication process, which typically takes 12 days. This high-frequency identification avoids issues of borrower selection and lower-frequency confounding macroeconomic factors.

As we said earlier, when the U.S. dollar Libor cross-currency basis becomes more negative, investing in leveraged loans become less attractive, all else being equal, for foreign investors that fund these positions in the FX swap market. The resulting lower demand for the loans is reflected in an upward adjustment of the interest rate spread (a positive spread flex), as illustrated in figure 3.

Figure 3, which is a bin scatter plot, shows changes in the average five-year U.S. dollar Libor cross-currency basis against nine major currencies over the syndication period on the x-axis and the effective spread flex, calculated as the interest rate spread flex plus the original issues discount (OID) flex divided by four, on the y-axis.⁸ When CIP deviations widen over the syndication period (a leftward movement along the x-axis), the effective spread flex increases (an upward movement along the y-axis). A 1 basis point decrease in the average cross-currency basis implies a 2.9 basis points higher effective spread flex—that is a 2.9 basis point increase in the effective interest rate the borrower pays on the loan. This effect is statistically significant at the 1% level of significance. This result is also shown in the regression table in the online appendix and is robust to alternative regression specifications.⁹

The effect of CIP deviations on borrowing costs is economically meaningful as well. Consider, for example, the period between February 15 and March 14, 2020, in the early phase of the COVID-19 crisis and before the Federal Reserve expanded its swap facilities. In that period, the average CIP deviation increased by 7 basis points, accounting for an increase in borrowing costs of 20 basis points (compared to a mean interest rates spread of 370 basis points). This reflects a 5% increase in the interest rate spread within a month.

Figure 3. Effect of CIP deviations on effective spread flex of leveraged loans

Effects of CIP deviations between the U.S. dollar and foreign currencies

A currency area's net U.S. investment position in long-term debt can be seen as a proxy for the extent to which a currency area may rely on FX swap markets to fund its investment in these assets. In line with our narrative, the larger a currency area's net U.S. investment position in long-term corporate debt is, the stronger are the effects of widening CIP deviations between the U.S. dollar and that currency on the interest rate spreads of leveraged loans.

This is illustrated in Figure 4. The y-axis of this figure shows the regression coefficients obtained from regressing effective spread flexes on the U.S. Libor cross-currency basis against individual currencies separately (columns 2–10 in table A of the online appendix). The x-axis indicates a currency area's net U.S. investment position in long-term corporate debt. Specifically, it shows the differences between a currency area's U.S. long-term corporate debt claims and its corporate debt liabilities toward the United States divided by the currency area's GDP.¹⁰ The negative correlation suggests that CIP deviations against currency areas with a larger net U.S. investment position in long-term corporate debt relative to GDP have stronger effects on spread flexes.

Figure 4. Heterogeneous effects of CIP deviations against individual currencies on the effective spread flex

Fed swap lines reduce CIP deviations and borrowing costs

CIP deviations between the U.S. dollar and foreign currencies widened significantly when the COVID-19 pandemic hit the global economy.¹¹ In response, the Federal Reserve and several other central banks announced the expansion and enhancement of U.S. dollar liquidity swap lines in the second half of March 2020. In addition, the Federal Reserve introduced a new temporary repurchase agreement facility for foreign monetary authorities (the FIMA repo facility). The expanded swap lines were met with strong demand. Subsequently, cross-currency basis spreads stabilized (figure 5).¹²

According to the Federal Reserve, "the dollar liquidity swap lines [have been] designed to help maintain the flow of credit to U.S. households and businesses by reducing risks to U.S. financial markets caused by financial stresses abroad."¹³ Our research summarized in this article suggests that this facility helped, among other things, ease credit conditions for U.S. borrowers in the leveraged loan market.¹⁴

Figure 5. CIP deviations in the COVID-19 era

References

Avdjiev, Stefan, Wenxin Du, Cathérine Koch, and Hyun Song Shin, 2019, "The dollar, bank leverage, and deviations from covered interest parity," American Economic Review: Insights, Vol. 1, No. 2, September, pp. 193–208. Crossref.

Bruche, Max, Frederic Malherbe, and Ralf R. Meisenzahl, forthcoming, "Pipeline risk in leveraged loan syndication," Review of Financial Studies. Crossref.

Cetorelli, Nicola, Linda S. Goldberg, and Fabiola Ravazzolo, 2020, "How Fed swap lines supported the U.S. corporate credit market amid COVID-19 strains," Liberty Street Economics, Federal Reserve Bank of New York, June 12, available online.

DeMarco, Laurie, Emily Liu, and Tim Schmidt-Eisenlohr, 2020, "Who owns U.S. CLO securities? An update by tranche," FEDS Notes, Board of Governors of the Federal Reserve System, June 25. Crossref.

Du, Wenxin, Alexander Tepper, and Adrien Verdelhan, 2018, "Deviations from covered interest rate parity," Journal of Finance, Vol. 73, No. 3, June, pp. 915–957. Crossref.

Irani, Rustom M., Rajkamal Iyer, Ralf R. Meisenzahl, and José-Luis Peydró, forthcoming, "The rise of shadow banking: Evidence from capital regulation," Review of Financial Studies.

Lee, Seung Jung, Dan Li, Ralf R. Meisenzahl, and Martin J. Sicilian, 2019, "The U.S. syndicated term loan market: Who holds what and when?," FEDS Notes, Board of Governors of the Federal Reserve System, November 25. Crossref.

Lee, Seung Jung, Lucy Qian Liu, and Viktors Stebunovs, forthcoming, "Risk-taking spillovers of U.S. monetary policy in the global market for U.S. dollar corporate loans," Journal of Banking & Finance. Crossref, .

Liao, Gordon Y., and Tony Zhang, 2020, "The hedging channel of exchange rate determination," Board of Governors of the Federal Reserve System, working paper, May. Crossref.

Meisenzahl, Ralf, Friederike Niepmann, and Tim Schmidt-Eisenlohr, 2020, "The dollar and corporate borrowing costs," Centre for Economic Policy Research, discussion paper, No. DP14892, June, available by subscription.

Niepmann, Friederike, and Tim Schmidt-Eisenlohr, 2019, "Institutional investors, the dollar, and U.S. credit conditions," International Finance Discussion Papers, Board of Governors of the Federal Reserve System, No. 1246, April. Crossref,

Appendix

Figure A. The Syndication Process and Timeline

Table A