How Hedging Strategies Manage Interest Rates During Inflation
Learn about the options for optimizing debt structure.
Beset by increased costs for their products and services, businesses must now add higher interest rates to the problems that need to be managed. As the Federal Reserve tackles inflation, those rates are forecast to climb even higher, putting pressure on margins and making it difficult to predict future cash flows, protect profits, and reduce losses. Fortunately, businesses can marshal a number of effective hedging solutions to manage their interest rate risk.
"Debt is a necessary vehicle for businesses to accelerate investments because they typically borrow to fund property, equipment, and acquisitions," said Tom Ritter, Managing Director for Financial Risk Management at Fifth Third Bank. Commercial borrowers repay debt over a fixed time period, expecting certainty about the amount of their payments. "But that certainty is contingent upon how they structure their debt," he said.
Borrowers Have Choices
A fixed-rate loan is best for most needs because debt repayment is predictable, reducing future volatility in cash flows. But fixed rates may not be available in the current rising-rate environment.
Lenders adjust to the higher cost of money by offering floating or variable rates tied to a benchmark, typically the prime rate or SOFR (the replacement for LIBOR in the U.S.). With a floating rate loan, the borrower faces increased debt-service costs and unpredictable future cash flows.
A third option, hedging, can help remove the uncertainty by fixing the rate for a period of time, making the cost of debt service predictable. Hedging represents a trade-off between the commitment of time versus uncertainty.
Determining the Best Plan of Action
Many commercial borrowers traditionally match short-term assets with short-term liabilities (i.e., floating rates) and long-term assets with long-term liabilities (e.g., utilizing fixed or synthetic fixed rates).
However, fully optimizing the debt capital structure of an organization typically requires a little more thought and strategy. According to Fifth Third’s Ritter, the optimal fixed and floating debt hinges on four pillars: leverage, liquidity, strategy for growth, and risk appetite.
- Leverage. Borrowers with a fair amount of leverage—or higher debt loads—are more sensitive to interest rate spikes and should therefore typically take less rate risk. Conversely, those with less debt may not be as concerned about rising rates, as debt service represents a lower draw on cash flow.
- Liquidity. Borrowers who have more cash and a lower debt load are generally not as concerned about rising rates. They can benefit from investing excess cash in higher-yielding instruments. But rising rates put pressure on borrowers with more debt and lower levels of access to cash.
- Growth strategy. Some borrowers maintain high leverage, but repay it quickly, effectively managing their risk by reducing their debt load. They may benefit from variable rate debt, depending on the intent and ability to repay their debt. Others are comfortable maintaining significant debt to invest in their business, make acquisitions, or purchase property. For them, a fixed rate may be more beneficial.
- Risk appetite. Conservative, low-risk tolerance borrowers typically seek fixed-rate financing to reduce uncertainty. Borrowers with a higher risk tolerance may be willing to take more floating-rate risk.
Hedging Instruments
A borrower’s overarching goal is to optimize the debt structure. Hedging strategies can do that by fixing the rate for a period of time. Some of the more common ones are swaps or options such as caps or collars.
- Swaps: A swap is an agreement between two parties to exchange cash flows for a specific time period and represents the lion’s share of hedging strategies. Swap contracts are typically aligned with the terms of the underlying credit facility, although the dollar amount or duration need not necessarily match the loan parameters—duration can be shorter or longer than the loan and can be less than the underlying amount. For example, a swap can be structured for only $5 million of a $10 million loan, or a borrower may choose to fix the rate for the entire loan. Swaps are used more often for longer-duration trades (five years is typical), though some lenders will arrange a swap for up to 10 years.
It is important to understand that if a swap contract is terminated prior to its scheduled maturity, it will have a value based on the expected remaining future cash flows for the remaining tenor of the trade. The trade will have value to one party and an offsetting cost to the other party depending on where rates have moved since the initial "rate lock." In a typical swap where the borrower fixed the rate with a bank, the early termination of the contract would result in a benefit to the borrower if the market replacement rate is higher than the fixed rate on the contract and vice versa if the replacement rate is lower.
- Interest Rate Options: As discussed above, interest rate swaps provide interest rate certainty, and in exchange for this certainty, the borrower foregoes the possibility of paying a lower variable rate of interest if realized rates fall below market expectations. Other alternative hedging strategies provide protection to borrowers against rising rates but keep some benefit if rates do not rise as much as expected. Interest rate options (IRO) give the purchaser interest rate protection at or above/below a certain level (the strike rate) for a predetermined period of time. There are various interest rate option structures, and two of the most common are discussed below:
- Caps: A cap is an option that limits the purchaser’s interest rate to a maximum level (the strike rate) for a stated period. The borrower benefits from a fixed rate when interest rates are higher than the strike rate, and a floating rate when rates are lower than the strike rate. In exchange for this interest rate protection, the purchaser pays an upfront fee, or premium. The higher the strike rate, the lower the premium and vice versa.
- Collars: A common collar structure combines the purchase of an interest rate cap (as described above) and the sale of an interest rate floor. The structure offers a variable rate of interest between the cap and floor strikes and an interest rate maximum at the cap strike. However, if interest rates are below the floor strike, the borrower’s interest expense will increase. Typically, the proceeds received from selling the floor fully offset the premium from purchasing the option, meaning that no upfront fee is needed. Options generally leave a borrower with more interest rate variability than a swap, but less risk than having all of the borrower’s debt floating, and can be an appropriate alternative.
Businesses need cash flow certainty in a rising-rate environment because the cost of servicing debt has an impact on cash flow and profits. Hedging can protect against fluctuating debt costs, and can be tailored to the borrower’s profile and needs. Combining the right credit structure and hedging vehicle is the key to predicting cash flow, protecting profits, and reducing losses.
Want more information about rate risk management? Arrange to speak with a Fifth Third expert on interest rate hedges.