Volatility and Interest Rate Hedging

Major world events – like the recent “Brexit” vote – often wreak havoc on interest rate markets. Some produce a swift drop in rates. Others precipitate a general rise. Many are mixed. The only consistent, predictable element is unpredictability.

While there is no way to keep major, market-affecting events from occurring, it is possible to insulate yourself from the effects. Hedging interest rate risk (usually on debt) offers stability and insurance. Of course, every corporation’s needs and priorities are different. What follows is a checklist of items to think about when considering interest rate hedging in the context of major, event-driven movements.

Don’t forget the ultimate goal of your hedge program.

Whether Brexit-caused swings left your company in or out of the money, a well-planned hedge program should always provide one thing: Predictability. If you used a swap to lock in rates at 3% some years ago, you are still experiencing 3% today. If you used a collar to set a ceiling, you’ll never experience rates higher than that cap rate. Whatever the market is doing, you should still be experiencing what was promised. The goal isn’t profit … it’s planning. So if current events are making the market rates look attractive, make sure that the rate is a rate the company can live with for the long term before you lock in.

Be sure hedges reflect your business reality.

Interest rate swings do not affect all corporates in the same way. While it is possible to assume that lower rates are universally positive, this is not always the case. Consequently, it is critical that hedges reflect the goals of (and realities faced by) each individual business. How are your clients, and therefore you, impacted by falling rates? Is it desirable to “lock in” a low rate if rates could get lower? Will there be a benefit in knowing exactly what the rate will be at a given point in the future? These questions – and more – must be answered before any action is taken.

Consider alternative instruments.

Periods of volatility can be an ideal time to consider alternative instruments, namely caps. A cap premium can be paid to take advantage of low rates, with absolute confidence that rates will never exceed a certain amount. Essentially, it insures the company against a rise in interest rates for the hedged period.

Remember that sub-zero interest rates aren’t impossible.

Some parts of the world are already experiencing negative interest rates, and – while unlikely – there’s nothing to say that it can’t happen in the U.S. While there is little chance banks would end up paying corporates (most debt contracts contain a clause saying an interest rate will never be less than zero), the fact that negative rates are possible should serve as an impetus for the review of debt documentation and gaining an understanding of potential implications.

Bring in an expert if needed.

Since corporates enter into new interest rate hedges relatively infrequently, it’s rare that Treasury departments have a high degree of internal expertise in the matter. Fortunately, experts are available to help evaluate your current exposures and potential responses to this or the next volatility-driving event.

Our IR hedging consultants are always ready to lend a hand; to speak with one, feel free to call 408-350-8580 or contact us today.