Insight & Analysis

Looking through the hedge

Published: Mar 2022

With analysts predicting that interest rates will rise faster than previously expected, corporates would be well advised to revisit their interest rate hedging strategies.

Hedge entrance to gardens

Having raised interest rates two months running, the Bank of England will be weighing up its next move carefully, mindful of rising inflation but also pressure on inflation-adjusted incomes. But while the ECB shows no sign of rushing into rate rises, on the other side of the Atlantic the Federal Reserve is expected to raise rates seven times this year.

Despite these upward movements, many corporates remain reluctant to hedge their interest rate exposure. There are many reasons why this might be the case, although Farah Lotia, Director of Interest Rate and Quantitative Analytics at Hedge Trackers, says it is often down to misunderstanding of the difference between the purpose of hedging and its perceived costs.

“If we take the example of a corporate that has raised variable rate debt and is looking at hedging it, in a low interest rate environment the analysis focuses on the monetary gain or loss upon settlement of the derivatives, which makes hedging seem less attractive,” she says.

However, the real purpose of hedging is to protect against movements as a result of changes in rate. So over time, as rates fall the savings on the debt are offset by the payments on the derivative (hedge). On a net basis, that offset has neutralised the corporate’s exposure and afforded it a known fixed cost on its debt.

Anticipation of rising rates – coupled with increases in oil prices and volatility in FX rates – has led to increased interest in hedging programmes. However, Lotia suggests that corporates with ongoing hedging protocols in place would have had better protection than entering these derivatives today.

“Other hurdles tend to be more logistical,” she adds. “Most derivatives are traded OTC and there are no readily available public databases of transaction costs for how much a bank should charge them for credit and what execution spread is reasonable.”

As outlined above, many factors feed into the cost of hedging, and duration also varies depending on the industry and type of business. Lotia observes that most hedging is in the five to seven year range but as inflationary fears continue to weigh on the market, maturities are continuing to extend.

“The market is also dealing with the challenges of reference rate reform,” she adds. “As more corporates adopt term SOFR as well as overnight indexed SOFR, we are seeing wider spreads around liquidity. That is especially the case when it comes to term SOFR since it is an option available to corporates only.”

Wilbur-Ellis (an international company with divisions in agribusiness, speciality chemicals and ingredients and feed) hedged its exposure in March 2020. Based on where rates have been and where they are predicted to go, it stands to be in a net-gain situation on a monetary basis.

The company entered into these hedges when rates were at some of their lowest levels so implementing them took a lot of analysis to fully capture and explain the true cost and – more importantly – the benefit to all stakeholders including the board, audit and control functions, the hedging committee, and credit providers.

“We proactively evaluated the benefit of hedging, which was to immunise against rate movements and have known, consistent interest rate exposure relative to debt issuance,” explains Corporate Treasurer Tamara Anthony.

Wilbur-Ellis entered into several swaps across a pool of counterparties to both diversify counterparty exposure and competitively negotiate ISDA terms and trading costs. “This saved the company several basis points in costs,” says Anthony. “More importantly, it enabled us to manage across covenants and keep aside additional risk appetite for future capital raises on favourable terms.”

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