Because in highly-rated securities, and the company’s investment policy

Because all three of our companies operate
internationally, they pose high risk to interest rate fluctuations. This is
very similar to what we saw in the previous section on exchange rate risk.

AAPL Exposure to Interest Rate Risk

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AAPL’s 10K indicates that its exposure to changes in
interest rates primarily relates to its investment portfolio and outstanding
debt. That said, it also indicates that AAPL’s interest income and expense are both
very much sensitive to fluctuations in U.S. interest rates. Changes in U.S.
interest rates will affect AAPL in a couple of ways: a) interest earned on AAPL’s
cash, cash equivalents and marketable securities, b) fair value of those
securities, as well as costs associated with hedging, and finally c) interest
paid on the AAPL’s debt. We can also find from the 10K that AAPL typically
invests in highly-rated securities, and the company’s investment policy limits
the amount of credit exposure to any one issuer. Furthermore AAPL’s investment
policy requires all investments to be in investment grade, with the key
objective of minimizing company’s risk of a potential principal loss.

illustrates AAPL’s outstanding floating-rate and fixed-rate term debts as of
September 2017 with varying maturities for an aggregate principal amount
of $104 billion. The figure 5.2
shows as of October, 2017(in billions), AAPL’s term debt and when the payments
are due by AAPL. AAPL’s credit rating1 from
Standard & Poor’s, Moody’s and Fitch group remains investment grade as
highlighted in figure 5.3. Which can
also be complimented by the Debt2-Equity
ratio AAPL maintains as shown in figure
5.4. From the 10K we also gather that as of September, 2017 and September,
2016, AAPL had outstanding floating-rate and fixed-rate notes with varying
maturities for an aggregate carrying amount of $103.7 billion and $78.9 billion,
respectively. We also find that for AAPL a 100 basis point increase in market
interest rates would cause interest expense on the AAPL’s debt as of September,
2017 and September, 2016 to increase by $376 million and $271 million

AAPL’s 10K shows that to manage interest rate risk it
enters into interest-rate swaps, options, other financial instruments. We know
interest rate swaps allows effective conversion of fixed-rate payments into
floating-rate payments or floating-rate payments into fixed-rate payments. As a
result gains and losses on term debt are generally offset by the corresponding
losses and gains on the related hedging instrument. We also find that to
manage interest rate risk on the U.S. dollar-denominated fixed-rate notes AAPL
entered into interest rate swaps which are highlighted in figure 5.5. Furthermore the 10K also highlights that to manage
foreign currency risk on AAPL’s foreign currency-denominated notes, the
organization has also entered into foreign currency swaps to effectively convert
these notes to U.S. dollar-denominated notes as a measure to offset its
interest rate risk.

HPQ Exposure to Interest Rate Risk

Now let’s look at the HPQ’s exposure to Interest Rate
Risk. HPQ’s 10K shows that the company is exposed to interest rate risk related
to debt it issues and its investment portfolio. HPQ issues long-term debt in
either U.S. dollars or foreign currencies based on market conditions at the
time of financing. The company’s aggregate future maturities of debt at face
value, including capital lease obligations as of October, 2016, are shown in figure 5.6. From figure 5.7 we see that HPQ’s borrowings over the period is slowing
down which is a good sign, meaning it has sufficient resources to fuel its

Credit rating15 for HPQ remains at an
investment grade level with moderate risk having a stable outlook. This
information can also be complimented by the Debt-Equity ratio HPQ maintains as
shown in figure 5.6. The company’s
10K confirms that in the fiscal year 2016, debt-to equity ratio decreased by
2.08x, primarily due to negative equity resulting from transfer of net assets
of $32.5 billion to Hewlett Packard Enterprise and redemption of $2.1 billion
of fixed-rate U.S. dollar global notes due to the separation.

Form the company’s 10K we see that to modify the
market risk exposures in connection with the debt and to achieve U.S. dollar
floating interest expense, HPQ engages in interest rate and currency swaps. The
10K also makes us aware that in order to hedge the fair value of certain fixed-rate
investments, HPQ enters into interest rate swaps that convert fixed interest
returns into variable interest returns. HPQ also uses cash flow hedges to hedge
the variability of LIBOR-based interest income received on certain
variable-rate investments and it further enters into interest rate swaps that
convert variable rate interest returns into fixed-rate interest returns.

From the 10K we further learn that HPQ utilizes
derivative contracts to offset the company’s exposure to interest rate risk.
Such derivative contracts do involve the risk from its counterparty’s non-performance,
which at times may further result in a loss. However the company estimates the
likelihood of this happening is very remote. HPQ uses derivative instruments,
primarily forwards, swaps, and options, to hedge certain interest rate
exposures. The derivative value of the Interest Rate contracts for periods
October 2016 and October 2015 are $48 million and $58million respectively.

Lenovo Exposure to Interest Rate Risk

Lastly we take a look at Lenovo’s exposure to Interest
Rate Risk. From the company’s annual report we find that like AAPL and HPQ,
Lenovo’s interest rate risk also arises from short-term and long-term
borrowings denominated in United States dollar. In figure 5.9 we see Lenovo’s short-term and long-term borrowings
denominated in United States dollar. The company’s exposure to all borrowings
to interest rate changes can be seen in figure


As we have found for Lenovo’s other risk exposures it
is the company’s ERM’s responsibility to define strategies to offset the
interest rate risk, through the use of appropriate interest rate hedging
instruments. From the company’s annual report we learn that Lenovo manages its
cash flow interest rate risk by using floating-to-fixed interest rate swaps.
This is also very similar to what we have seen being followed in our other two
companies. For the interest rate swap, Lenovo agrees with other parties to
exchange, at specified intervals (typically quarterly), the difference between
fixed contract rates and floating-rate interest amounts calculated by reference
to the agreed notional amounts.

Analyzing Approaches on Interest Rate Risk

In all three of our companies we find that the most
popular way they plan to offset the Interest Rate Risk exposure if to make use
of common derivative instruments or to use the approach of interest rate swap.
As we have not seen any usage of any specialized derivative we would like to
also recommend that in addition to their existing strategies to manage Interest
Rate Risk exposure, Interest Rate Collar (derivative instrument) can also be
looked into.

An interest rate collar is actually an investment
strategy that uses derivatives to hedge an investor’s exposure to interest rate
fluctuations. An Interest Rate Collar sets a maximum (which is termed as cap)
and minimum (which is termed as floor) boundary on a given floating rate (such
as LIBOR or Prime). If the floating rate rises above the maximum or cap level,
the company is credited for the difference. If the floating rate falls below
the minimum or floor level, the company is debited for the difference. Lastly
one of the alternate alternative methods for companies to mitigate their
exposure is to issue bonds to raise capital. This is something AAPL in November
20174. The
company issued $7 billion of debt in latest fund raising for $300 billion
shareholder program. AAPL had repeatedly borrowed in the corporate bond market
to reward its shareholders, rather than repatriate some of the $252.3 billion
in cash. Proceeds of the deal will be used for catchall ‘general corporate
purposes’ which includes share buybacks and dividend payments.

We now explore the bond landscape and outlook for near
future, 2018. Figure 5.11 shows the
trends in Government bonds, corporate bonds and Treasury bills. We see that the
long term treasure yield curve is flattening, signaling a) weaker economy or b)
Fed raising rates too quickly. Mostly the outlook looks neutral for 2018. As we
know Fed has already planned for three more quarter-point increases in 2018.
This may hurt traditional bond prices, however investments with floating coupon
rates may benefit from future Fed rate hikes. High-grade investment-grade
corporate bonds, may remain a fair alternative to equities, which are very
expensive now. Bond market is expecting fewer rate hikes, on the view that
economy is growing too slowly and inflation is so low. Figure 5.12 shows the typical impacts on increase in Fed rates. We
can see that Fed funds rate and one-year Treasury rate track each other very
closely, however the interest rate on a 10-year Treasury bond does not. So it
is safe to conclude that the projected increase in fed funds rate for 2018 will
successfully raise short-term interest rates but have a limited impact on
long-term interest rates.

1 Moody’s,  S, Fitch

2 Debt for this
ratio is Debt minus Cash.


Apple issues
$7 billion of debt


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