“How do I manage treasury when it looks like rates might rise?”

Michael N. Berkowitz, Managing Director, Head of Global & North America Liquidity Product Management, Treasury and Trade Solutions, Citi:

In a rising rate environment, treasurers should review investment horizons to ensure that capital is preserved and liquidity is maintained. As all non-overnight investments bear an inherent level of interest rate risk, rising rates will have an impact on the current and future values of existing cash holdings, as well as influence the relative attractiveness of different investments for meeting specific investment needs.

With that in mind, corporate treasurers may want to adjust their interest rate exposures and consider investments with shorter duration.

Mitigating risk with short duration investments.

Having a solid understanding of how various cash investments are impacted by interest rates allows treasurers to take action to mitigate the impact of a rising interest rate cycle. Concentrating cash globally or regionally can also improve treasury efficiency, increasing interest income and reducing interest expense. The following is a summary of short-term investments and their characteristics:

Overnight bank deposits:

Rates tend to track rises in interest rates fairly closely, although treasurers should review counterparty credit risk associated with the depository bank. Certain bank deposits provide companies with the option of earning credits to offset fees, interest or both.

Time deposits:

Time deposits can offer higher yields but tend to catch rate increases with a lag as they need to wait out the term of the deposit before being reset to a higher rate. Time deposits carry the same counterparty risk as overnight deposits but increase liquidity risk. Certain evergreen or minimum maturity time deposits offer attractive yields and increased liquidity versus longer-term-time deposits with a 31-day call feature.

Money market funds (MMFs):

Compared to overnight bank deposits and term deposits, counterparty credit risk is significantly more diversified and yields are in line with market rates (with some lag). On the other hand, US Prime funds can impose gates and fees for investors and have floating net asset values (NAVs).

To better prepare for and navigate in a rate rising environment, it’s critical for treasurers to design and deploy a robust investment strategy that recognises trade-offs in yield, safety and liquidity.

Yvonne Welsh, Treasury Advisory Expert, PwC:

With positive growth projections, the macroeconomic landscape is being set for potential gradual interest rate increases in major global economies after being at historically low levels for many years. While no two organisations are the same in their exposure to such rises, we believe this new environment is an opportunity for the treasurer to add significant value, whether from a cash, funding or FX perspective.

Firstly, in relation to cash, rising rates present the opportunity to earn improved returns on idle or investment cash balances. When they do happen, the differential between the more favoured short-term investments – eg bank deposits or MMFs)– and other investment options such as separately managed portfolio, will likely widen.

Additionally, different categories of investments will have varying “lag effects”. When these factors are considered against the context of changing MMF regulation and the reduced willingness of banks to take on corporate deposits, upticks in rates could be the impetus for such treasurers adopting a more dynamic investment approach. However, before suggesting this, treasurers should be clear on their board appetite for risk in the changing rate environment and have in mind the additional monitoring and research required to be successful.

The levers to consider in the context of borrowing are twofold. One is managing the risk on the overall portfolio. It could be useful to explore the possibility of accelerating the refinancing of existing debt and lengthening duration when doing so. Specifically, in relation to existing floating debt, while it is likely that any related hedging activity will already have incorporated anticipated rate increases, pre-emptive action may provide longer-term certainty on interest costs.

The second aspect is optimising operational processes to reduce borrowing requirements and related interest cost. A reliable cash flow forecast is not only required to facilitate optimal investment activity but is essential for monitoring debt covenants. It sounds simple but forecasts need to reflect the possible increased interest costs, commercial impacts and have appropriate sensitivity analysis in order to build the most realistic and accurate cash requirements. Additionally, working to release any trapped/idle balances across geographies will release cash to pay down debt – in particular floating rate debt. In the current low-interest rate environment some companies may have managed idle cash in a benign fashion, however, solutions to access working capital improvements such as supply chain financing may become more compelling in a rate-rising backdrop.

Finally, FX. Typically, as interest rates increase a currency strengthens and adjustments in monetary policy will follow at varying points in time. Companies with international operations will, therefore, need to assess the implications of this potential additional volatility in FX rates from both a commercial and financing perspective. For those with existing hedging programmes in place, action should be considered to ensure this strategy remains relevant and effective as rates increase. For those without a hedging programme now may be the time to consider how to gain better visibility of exposures, examine sensitivities and explore the use of hedging instruments to smooth potential volatility and erosion of earnings.

Sander Van Tol, Partner, Zanders:

Corporate treasuries are used to operating in a low-interest rate environment. The main question then for corporate treasurers is how to prepare for a potential hike in interest rates?

Before answering this question, it is good to first look at the concept of interest rate risk. To determine the basic exposure of your company, the first step is to look at the net position; are you a net borrower or investor?

In this answer we are looking at interest rate risk management from a net borrower’s perspective, meaning that an increase in interest rates will lead to an increase of the interest expense line in the P&L of the company. An increase in interest expenses also has an indirect effect via the interest coverage ratio; meaning that a potential increase in interest rate can lead to a potential breach of the ICR covenant.

Interest rates may also impact the pension obligations of corporations. Normally we see that future liabilities under a defined benefit (DB) pension plan will decrease as a result of an interest increase (future liabilities are discounted using a higher discount rate).

The interest expense of the company is normally a combination of interest paid on a diversified funding portfolio, which can consist of drawings under your revolving credit facility, overnight debit positions and loan term funding like terms loans, private placements and bonds. Furthermore, interest paid on financial and operational leases are part of the interest rate risk exposure.

When we decompose the interest rate exposure further, one notes that interest paid is a combination of a reference/benchmark rate and a specific credit margin. This can be seen quite clearly in revolving credit facilities which use a Libor/Euribor reference rate depending on the period of the drawing (normally three or six months) plus a credit margin depending on a leverage ratio or credit rating.

For long-term instruments like bonds and private placements, the reference rate is less clearly defined but normally is dependent on long-term interest benchmark rates, like swap rates or government yields. Furthermore, the credit margin is fixed until final repayment. The decomposition of the interest rate on financial and operational leases is harder to make. Normally leases are using one all-in interest rate. For overdraft facilities, the interest rate exposure is sometimes even more opaque because banks charge interest based on their own, bank-specific, reference rate.

So why is the decomposition of interest rate risk exposure of importance? This has to do with the ability of corporate treasuries to hedge their interest rate exposure. With interest rate derivatives like swaps, caps and swaptions, one can hedge a potential increase of a reference rate or benchmark rate, but not the credit margin. So, it is good to understand that interest rate risk hedging can provide companies with relative protection against an interest rate increase but not a total protection of the interest expense. In case companies are looking to hedge their total interest rate exposure, including the credit margin component, it is most beneficial to look at either amending or extending the current credit facilities and/or a liability management exercise in the debt capital market to profit from current market conditions on the long term.

Corporates looking to brace themselves for a rise in interest rates can also use derivatives. Most suitable derivatives to hedge the risk of a future interest rate hike in the long term are forward starting swaps and swaptions. With forwards starting swaps, companies can fix the swap rate they will use in the future. This instrument can be used even if the underlying funding is not secured yet. Generally speaking, corporate treasuries will use forward starting swaps in case there is a high degree of certainty about the future funding requirement and the company has a view that the interest rate is likely to increase.

If the underlying exposure is less certain, or the view of a potential hike in interest rates is more unclear, treasury can potentially enter into swaption in which the corporation is buying the option to enter into an interest rate swap at the exercise date in which it is paying the fixed leg of the swap. The preference for one instrument over the other is dependent on the price of derivative and the view on interest rate changes.