Case 033Bond issuance and executionHard
Korvath Industries plans a Rs 1,000 crore 10-year bond in three months and fears rates will rise. Which derivative would you use to lock the rate, and what happens if government yields rise 40 basis points and its credit spread widens 20?
1The situation
Korvath Industries, an engineering group rated in the AA range, plans to issue Rs 1,000 crore of 10-year bonds in three months, once its annual results are out. Today the 10-year government bond yields 7.00% and Korvath's bonds price about 120 basis points over it, so a deal today would carry a coupon of about 8.20%.
The treasurer fears yields will rise before the deal and asks the syndicate desk how to protect the coupon now. Assume the bond is issued at par and use annual coupons.
2Your task
Recommend the hedge, show its result if government yields rise 40 basis points and Korvath's spread widens 20, and say what the hedge cannot do.
Quick check
Yields rise 40 and the spread widens 20. How much of the 60 basis point rise does a rate lock on government yields cover?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Use a rate lock on the 10-year government yield, a forward sale of the bond or bond futures, or a forward-starting pay-fixed swap, sized to the new bond's PV01. If yields rise 40 and the spread 20, the coupon goes from 8.20% to 8.80%. The hedge gains about Rs 26 crore, offsetting the 40 basis points, but the 20 basis points of spread costs about Rs 13 crore in present value. A rate lock fixes the government yield, never the credit spread.
Step 1Which derivative locks the rate, and how is it sized?
Think of booking a hotel room months ahead at today's rate: you do not stay yet, but the price is fixed. A rate lockAn agreement that pays the issuer if the reference yield rises before a set date and costs it if the yield falls, fixing the benchmark part of a future coupon. fixes today's benchmark yield for a bond you will issue later. Korvath can sell 10-year government bond futures, agree a forward sale of the benchmark bond with a bank, or pay fixed on a forward-starting swap. Size it so that one basis point moves the hedge by the same rupees as it moves the new bond's cost: the bond's PV01 at issue is about Rs 0.647 crore per basis point.
Step 2What is the result when yields rise 40 and the spread widens 20?
The coupon rises from 8.20% to 8.80%. Sixty basis points on Rs 1,000 crore is Rs 6 crore a year for ten years, about Rs 38.8 crore in present value. The hedge settles for 40 basis points times the PV01, about Rs 25.9 crore, so the net cost is the 20 basis points of spread, about Rs 12.9 crore. Korvath pays 8.80% on the bond but, counting the hedge gain, its effective coupon is 8.40%: the locked 8.20% plus its own spread widening.
Step 3What happens if yields fall instead?
The hedge is a lock, not insurance, so it cuts both ways. If government yields fall 40 basis points, Korvath issues at a lower coupon but pays out on the hedge, and its effective coupon is still 8.20% plus the spread change. Hedged, every scenario lands on the locked level plus Korvath's own spread move; unhedged, the coupon swings with both. The treasurer should expect to explain a hedge loss in a falling market, which is why boards approve hedging policy before, not after.
Step 4What can the hedge not do?
Three limits, each worth naming. It does not touch the credit spread, which is Korvath's own risk and is managed by timing and by keeping results clean before launch. It carries basis risk: futures or swaps may not move exactly with the government bond Korvath prices off. And if the deal is delayed or pulled, the hedge is left as an open position, so agree hedge accounting with the auditors and settle the hedge on the day the bond prices.
Where candidates lose it
The common error is claiming the hedge locks the whole coupon. It locks the benchmark. When the interviewer adds spread widening to the scenario, the point is to see whether you separate the two components.
The second is recommending an option without costing it. A payer swaption caps the benchmark and keeps the upside if yields fall, but the premium is paid up front and is often a hard sell to a treasurer who only wants certainty.
What the interviewer asks next
- When would you use a payer swaption instead of a lock, and what would it cost Korvath?
- The results are delayed and the deal slips three months. What do you do with the hedge?
- How would you hedge the benchmark if the bond were to be priced over the swap curve instead?
- Can Korvath do anything about the spread risk?
Asked at Goldman Sachs, Fixed Income Currency and Commodities, London, 2025 (Wall Street Oasis): I was given a scenario and was asked what kind of derivative strategy I would use for that trade
Company names and figures are illustrative.