Interest Rates - To Hedge, Or not to Hedge?
Author:
Aidan Andrews
Used as part of an informed treasury risk management policy, hedging may help your company out-perform its competitors.
An argument can be made at the moment to suggest that the long awaited gradual recovery in the eurozone economy might be just around the corner.
Certainly the depreciation of the Euro against the US Dollar and Sterling, which we have seen in the first half of this year, should remove some of the major factors holding back eurozone growth. In fact, this already seems to be reflected in an improvement in business sentiment and data within the eurozone.
In a global context, external demand also looks to be more supportive in the second quarter of 2005 as the global economy appears to have shrugged off its first quarter concerns of a slowdown in global manufacturing and of high inventory levels. There are also some signs of a pick-up in the eurozone housing market, which would help boost consumption rates.
The only negative factors appear to be poor employment data and the high price of oil both of which could have a negative effect on consumption in the eurozone. The impact of high oil prices could mean that any recovery would be modest at best. Overall, forecasts from AIB’s Economic Research Unit expect GDP growth in the eurozone area to average less than 1.5% in 2005 and forecast GDP growth of 1.8% in 2006.
EUROZONE INTEREST RATES?
The eurozone base rate has been at 2% since June 2003. With the eurozone economy losing momentum in Quarter 2 2005 there has been growing pressure for an interest rate cut. Despite this pressure I believe that this is unlikely as inflation would have to fall well below 2%, or the economy to weaken significantly, before the ECB would consider cutting rates. This weakening of the economy is unlikely to happen as the high commodity price for oil and the decline in the Euro currency are likely to keep inflation at or above 2%. Recently, ECB president Jean-Claude Trichet stated that interest rates are appropriate at the moment and that ECB is not preparing markets for either an interest rate cut or increase. In fact it looks unlikely that we will see any hike in the eurozone base rate until the second half of 2006 at the earliest, given the fragility of the economy and very subdued wage and inflationary pressures.
With the eurozone base rate at an all time low (2% for the past two years) the danger is that companies may be lulled into a false sense of security in terms of the potential for borrowing rates to actually move against them. The issue of long-term interest rate risk exposure should not be taken lightly. The proper management of financial risk is an important function common to all businesses, regardless of scale. In an increasingly competitive marketplace, profit margins are consistently under threat, and the impact of a significantly higher cost of funds could have a very real implication for the long-term profitability & survival of a business.
The management of long-term debt is a key concern for every business. Any investment that is financed by long-term debt results in an interest rate risk exposure, which may exist across several business and interest rate cycles. For this reason, an evaluation of a company's interest rate risk management policy should be undertaken at least twice yearly over the life of a borrowing. This review should be an integral part of the organisation’s treasury risk management policy and should look at:
- Risk Management planning
- Identification and evaluation of the treasury risks facing the company
- Establishment of a treasury risk management policy in line with business objectives
- Evaluation of the Interest Rate Risk Management strategies available
- Evaluation of the available risk management products (e.g. Interest Rate Swaps, Caps, Collars, Swaptions and Cross Currency Interest Rate Swaps)
- Determination of optimum hedging levels
-Identification of strategies to help achieve specific business goals
- Tailoring of risk management solutions to meet ongoing business requirements and cash flow.
The Certainty / Opportunity ratio should also be carefully considered by any company with a long-term debt exposure. This opens a wider debate over fixed versus floating interest rates. Without doubt, a robust treasury policy is one where the full range of suitable risk management mechanisms is considered to help hedge exposures.
Most companies will adopt a mix of solutions to produce the desired result.
It is clear that with medium to long-term rates at close to historic lows, there is plenty of value in considering hedging mechanisms at present.
For example the five-year fixed rate alone was a full 110 basis points (1.1%) lower at the end of August than at the end of June of last year.
The major approaches / products that can be used in relation to the management of a company's risk management exposure are:
- Remain on Variable / Floating Rate Basis
Many companies have decided to keep their loans on a variable rate basis over the past few years. This strategy has worked well in so far as variable rates have remained well below fixed rates due to the sluggish performance of the Eurozone economy. However, the gap between variable and fixed rates has narrowed significantly in recent times. Variable rates will inevitably rise and a company with long-term debt should seriously consider the impact of such a hike on their cash flow.
- Fixed Rate Loan / Interest Rate Swap
A company can choose to fix all or part of their medium to long-term debt. Here the company pays a fixed interest rate on the amount borrowed and is protected against any upward movement in rates. This provides certainty as regards cash flow planning. There are two main limitations of fixed rates / swaps versus floating rates. One is the opportunity cost of fixing a rate if the variable rate subsequently remains below the fixed level. The other limitation is that a company may have to pay a 'break cost' to get out of a fixed rate loan if they want to repay the loan early. Any 'break cost' would be based on the level of the fixed rate loan versus the current interest rates available in the market required to terminate the swap.
- Interest Rate Cap
An interest rate cap is used to protect a company against interest rates rising above a certain agreed level while still allowing them to take advantage of the benefit of falling interest rates. It does this by setting an upper limit (or cap) on the floating interest rate that the company has to pay. This acts as a type of insurance to prevent a situation where the company has to pay a borrowing cost over this 'capped' level. If the variable interest rate goes over the capped rate then the bank pays the company the difference between the capped rate and prevailing floating rate - which brings their borrowing cost back to the capped rate. This allows a company to benefit from lower interest rates should they arise. The interest rate cap attracts an upfront premium the level of which will depend on the amount, desired protection level, volatility and time period.
- Interest Rate Collar
If a company wants to reduce the cost of the upfront premium of a cap, it may choose an interest rate collar instead. This is where a company buys a 'cap' and sells a 'floor'. By buying an interest rate cap the company protects itself against higher interest rates but may take advantage of lower interest rates without any limit. By selling a floor, the company gives up some of the possible benefit of lower interest rates - how much benefit the company gives up depends on the interest rate level at which it sells the floor. If the value of the floor sold is the same as the cost of the cap bought, this is known as a 'Zero Cost Collar'. The term 'collar' referring to the fact that the interest rate the company pays will never be more than the cap level or lower than the floor level.
- Interest Rate Swaption
This is also known as an option on a swap. It gives a company the right but not the obligation to avail of a pre-determined fixed rate at a future date. Essentially, it gives a company protection against an increase in rates while giving the company the freedom to enjoy cheaper borrowing costs if rates fall. If a company wishes to enter into a swaption, it will need to pay a premium upfront. This product is suitable in situations where a company may be unsure if borrowing will be a requirement (e.g. in a tender situation).
CONCLUSION
In summary, hedging is important because it assists the responsible management of a company's debt exposure and delivers the following business benefits:
- In a changing interest rate environment it may help your company to out-perform competitors who do not actively manage financial risk
- It may protect your company from financial shocks
- It facilitates more predictable cash flow planning
- The business is likely to be more resilient as a result of an active approach to managing interest rate exposures.
The market expectation for short-term rates at present is benign. Most analysts have a neutral view of short-term rates but foresee the possibility of small increases in 2006. However, with medium to long term rates so low, and with the market expecting these rates to firm up towards the end of next year, it makes sense a to review your long term debt exposures.
Whatever your view on interest rates, any company with a long-term debt exposure should adopt a prudent, flexible and considered approach towards managing the risk such an exposure represents. The company that decides to remain on a variable rate basis (after having carried a full review of their interest rate risk policy) is much better served than a company, which fails to evaluate these exposures.
The methods I have outlined may not be suitable for your particular circumstances so, as always, you should consult your professional financial advisor.