What it means
When a company issues a bond, its interest rate is built from two pieces: a government benchmark yield plus a credit spread that reflects the company's own risk. A Treasury lock deals only with the first piece, the benchmark yield, which can move a lot in the weeks before the deal is priced.
The company agrees a reference yield with a bank and a notional amount, which is the face value used for calculations although no one lends or borrows it. If benchmark yields rise before the lock ends, the bank pays the company; if they fall, the company pays the bank.
The payment is meant to offset the change in the company's real borrowing cost. When yields rise, the company pays more on its new bond but receives a cash payment from the lock, and when yields fall it pays less on the bond but hands cash to the bank.
The net effect is a borrowing cost close to the one the company locked in. The size of the payment depends on the notional amount, the change in yield and the sensitivity of the reference bond's price to yield changes.
That sensitivity is usually quoted as DV01, the dollar change in value for a one basis point (0.01%) move in yield. A nuance is that a lock removes the benefit of falling yields as well as the risk of rising ones.
Treasurers who expect rates to fall may prefer to leave the exposure open or use an option-based hedge, which costs a fee but keeps the upside. Another point is accounting.
A lock that qualifies as a hedge of a forecast debt issue generally has its gain or loss held in equity and then released into interest expense over the life of the new debt, so the benefit shows up gradually.
In practice
Real-world examples.
Example
A utility plans a $500,000,000 bond sale after its board meets in six weeks. The treasurer enters a Treasury lock now so that a jump in benchmark yields before the sale does not raise the cost of the issue. When the bond is priced, the cash received from the lock softens the higher coupon.
Example
A listed property group has agreed to buy a business and will fund it with new notes once regulators approve the deal. Approval is uncertain on timing, so the finance director locks the benchmark yield with a lock that can be terminated early. If the deal falls through, the lock is closed out and any gain or loss is realised.
Example
A healthcare operator with a fixed construction budget locks the benchmark yield for a planned borrowing. The chief financial officer wants certainty about the interest bill because the project's returns are thin. The lock leaves only the credit spread to be negotiated on the day.
Formula
Calculation
Settlement payment = (Yield at settlement - Locked yield) in basis points x DV01 of the notional amount
A company plans to issue ten-year debt in a few weeks and enters a Treasury lock on a notional of $50,000,000 at a locked yield of 4.00%. The DV01 of that position is $40,000 per basis point. When the lock is settled, the benchmark yield has risen to 4.50%, which is 50 basis points higher. Settlement payment received by the company = 50 x $40,000 = $2,000,000. The company then prices its bond at the higher market rate, which costs it extra interest of roughly the same present value, so the $2,000,000 receipt offsets that extra cost. Had yields instead fallen to 3.50%, the company would have paid 50 x $40,000 = $2,000,000, and its new bond would have been correspondingly cheaper.Case study
Seen in the real world.
Ridgeway Power is an illustrative, fictional regional utility that needed to raise $200,000,000 in ten-year bonds after a regulatory hearing. The treasurer was worried because a one percentage point rise in benchmark yields would add $2,000,000 a year in interest, and the hearing date left a six-week gap.
The team entered a Treasury lock on a notional of $200,000,000 at a locked yield of 4.20%. By pricing day the benchmark yield had risen to 4.45%, a rise of 25 basis points, and with a DV01 of $160,000 the lock paid out 25 x $160,000 = $4,000,000.
In the illustrative outcome, the new bonds carried a higher coupon than the plan assumed, but the $4,000,000 receipt covered most of the extra interest over the life of the bonds. The board noted that the same lock would have cost money had yields fallen, and accepted that as the price of certainty.
Watch out
Common mistakes.
- Assuming a Treasury lock fixes the company's whole interest rate, when it only fixes the government benchmark part and leaves the credit spread exposed.
- Thinking a lock is free protection, when it gives up the gain if yields fall and can require a cash payment to the bank.
- Locking a date that does not match the real pricing date of the bond, which leaves a mismatch if the issue is delayed.
Questions
People also ask.
How is a Treasury lock different from a forward-starting interest rate swap?
A lock fixes only the government yield and is settled once in cash, while a forward-starting swap converts a whole floating or fixed rate stream over many years.
Does the company actually buy any government bonds?
No, the contract is cash settled, so only the difference between the locked yield and the market yield is paid, based on the notional amount.
When does the gain or loss get recognised in the accounts?
If the lock qualifies for hedge accounting, the gain or loss is usually deferred and released into interest expense over the life of the debt, rather than hitting profit on settlement day.
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