With inflation at 7.9 percent, the Fed poised to hike rates, and US Treasury yields already climbing rapidly, I can say one thing for sure: All companies—large, medium, or small—should assess their interest rate risk and make a plan for what lies ahead.
What’s Happening
Since mid-November, the yield on the 5-Year US Treasury Note has increased from 1.25 percent to 1.95 percent and the yield on the 10-Year US Treasury Note has increased from 1.64 percent to 2 percent.
The Federal Reserve made its last quantitative easing bond purchases March 11th and has clearly signaled plans to raise rates this year to try to tame inflation. Economists are forecasting anywhere from four to seven Fed rate hikes within the next year with more to come in 2023. Bank of the West Chief Economist Scott Anderson predicts five hikes this year, with the first one coming at the March 15-16 FOMC meeting.
How Treasurers Can Prepare
For treasurers who want to get ahead of this rate cycle, a good starting point is to look at your company’s risk policy. It’s probably been gathering dust during the benign interest rate environment of recent years, but in times like this, documented guidelines for risk and governance can be a valuable touchstone. Once you understand the company’s approach to risk, the next step is to run financial scenarios using a range of rate forecasts that will give you a sense of your company’s exposure to interest rate risk across various future rate paths.
If these forecasts cause concern, then you may want to look at various hedging strategies. I can assure you that you won’t be alone. Lately, we’ve been talking a lot with corporate clients about hedging strategies. From my team’s recent conversations, I want to share three strategies for new hedges (note that new hedges are now tied to SOFR) and two ideas for potentially modifying existing hedges:
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5-year fixed-rate swap
With rates expected to rise steadily this year and next, a basic strategy is to hedge a company’s rate exposure with a 5-year fixed-rate swap. Treasurers may want to leverage interest rate swaps to reach cash flow goals, lower rate risk, and protect against the new rate hike cycle uncertainty. Five-year fixed swap rates are around 2 percent, and Russia’s recent actions have substantially increased volatility. Think about it this way: With one-month Term SOFR already higher than 0.25 percent, it will take only six quarter-point rate hikes to get to 1.75 percent.
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Cap corridors
We’ve been talking more in the current market about cap corridors, a hedge that combines buying an interest rate cap and selling a cap with a higher strike price. For companies that can tolerate higher rates, buying a cap at 2 percent and selling a cap at 3 percent may be an attractive way to mitigate some interest rate risk while reducing the upfront premium paid when compared to buying only a cap.
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Cancellable swaps
None of this is to say that we are immediately returning to the double-digit rates of the 1970s and ’80s, as the relative flattening of the yield curve beyond four years suggests otherwise. Perhaps the yield curve flattening reflects the possibility that the central bank tightening might lead to an eventual recession? This expectation diversity may create an opportunity to lock in a rate for five years while adding a three-year cancellation option that gives the swap holder the right to cancel the swap at the three-year point at no cost. If the swap holder elects to cancel it, the swap would simply cease and the holder’s borrowing rate would revert to the current SOFR rate at that time. If rates are higher at that time, you can continue in the swap as you had the first three years.
Another way to consider the recent market dynamics is in regard to a company’s current swaps, as there may be a positive value that can be tapped by restructuring or rebalancing the hedge. Here are two approaches generating interest among treasurers we’ve been talking to:
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Shorten the tenor of existing swaps
By reducing the existing tenor on longer-term swaps by a couple of years, a company may be able to take that positive value in the later months of the swap to buy down the overall rate and shorten the existing maturity.
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Apply revised borrowing forecast to existing hedges
Now may be a good time to compare current borrowing projections to the prior borrowing forecasts that a company used to set the notional amount for existing hedges. If the company has lowered its borrowing forecast, existing swaps may have some positive value creating an opportunity to revise the notionals without a cost.
What I’ve shared here are the highlights of discussions we’ve had over the last few months as conversations with corporate customers have increasingly turned to hedging. What any company does as this rate cycle begins depends on myriad factors, including risk policies, company size, debt levels, and interest rate forecasts. As always, be sure to consult with your financial, hedge, and accounting advisors, as now may be the time to take a fresh look at hedging strategies that can help reduce risk and adapt to the evolving economic reality.
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