Interest Rate Hedging for Mid-Market Companies
For many mid-market companies, interest rate hedging just isn’t on the radar. After years of ultra low interest rates, many mid-market companies have become comfortably numb to the impact that rising rates could have on their profitability. The purpose of this guide is not to direct you in attempts to time the market and capture the lowest possible borrowing costs. Rather, the goal is to help you really quantify how exposed your company is, or isn’t, to rising interest rates. Likewise, this guide is about defining what are tolerable outcomes and what would be unacceptable. It’s about formulating the right hedging strategy to ensure unacceptable risks are eliminated. Equally, it’s about ensuring that the right stakeholders have understood the interest rate risks your company faces, and support the strategy to accept or mitigate them.
Here is a practical 5-step process to help inform your analysis about interest rate risk and likewise, how to address it.
Step 1 – take an inventory
How exposed to interest rate risk is your company?
Would a move of x percent have unacceptable consequences, be a nuisance, or really not matter at all? Step one is about putting some numbers around potential outcomes. Start by identifying:
- What type of debt does the company have now, and what additional borrowing do you plan? These might include revolving credit lines, term loans for equipment or fixed assets, equipment leases, or mortgages
- For each of the above, list
- Now calculate the total amount of debt that is exposed to floating interest rates. Multiply that by a few different potential rate scenarios (e.g. rates rise 1%, or 3.5%) to determine what the dollar impact would be to your company. How does this figure compare with your company’s net income. Evaluate how material these potential outcomes are to the company’s profit and critically, its ability to cover its obligations. Are any of these scenarios unacceptable? Are they undesirable, or not material at all? Consider the impact if these changes occurred quickly, or gradually over the next 2-3 years
Does your company currently have an interest rate hedging policy?
- what is the policy, when was it last reviewed, and importantly, who in the company is responsible for overseeing it
- what does the policy say about the proportion of fixed vs. floating rate debt your company will operate with
- can you clearly articulate to your key stakeholders including management, board of directors, your bank
Are there “second order” impacts of higher interest rates.
For example, do most of your customers buy from you using credit? If rates were higher, might your sales might decline? This is sometimes the case with home builders or sellers of large ticket items.
If you lease equipment using fixed rate leases, have you evaluated the potential for cost savings by using floating rate leases combined with an interest rate hedge?
Step 2 – consider alternatives and construct a hedging strategy
Did your analysis indicate that rising interest rates would generate unacceptable or undesirable outcomes for your company? If yes, it is sensible to keep moving this process forward.
A sound interest rate hedging strategy
A sound interest rate hedging policy begins with establishing parameters for what is an acceptable amount of risk. This often takes the form of setting a target range for the proportion of floating rate debt the company can have compared to its total debt. In setting these limits you may want to consider a few specific features of your business, like
- How leveraged is your business. Generally, companies with higher leverage are less able to tolerate increases in interest expense. This is even more true if the company’s profit margins are thin.
- How seasonal is the business, or how much does the amount of borrowing vary over the course of the year. Related to this is any plans you have to repay debt. Fixed rate debt often has prepayment restrictions or penalties that should be considered.
- Consider the financial covenants in your loan agreements. Companies that have limited ability to withstand higher interest costs before breaching debt covenants (e.g. debt service ratio or minimum interest coverage) tend to benefit from a greater portion of fixed rate debt or the use of caps or collars.
From here you can start crafting your strategy to rebalance your rate risk so it is in line with the parameters you set for rate exposure. This is matching, to the largest extent possible, the hedging instrument with the specifics of the debt you are trying to hedge. Look first at what is the basis upon which your interest is charged on your floating rate debt. Is it Libor, Prime, SOFR, or some other basis. There may be several alternatives to either match the same basis or hedge with an instrument that is highly correlated to the rate on your debt.
Futures vs. forwards for interest rate hedging
Depending on the size of your business and hedging needs, you may have several different alternatives available to you in how to execute. For example, your bank may offer interest rate swaps and other derivatives like caps and collars. Alternatively, you can access futures and futures options markets through a provider like Kilo Futures. Both of these alternatives have benefits and drawbacks. Here are the key differences you will want to consider.
Futures are standardized contracts traded on a regulated exchange. Settlement takes place through a clearinghouse. In contrast, swaps are privately negotiated, bilateral contracts between two parties. This usually means a company and its bank. A noted benefit of swaps is the ability to tailor the specific terms like payment dates and maturities.
Pricing and execution
In terms of pricing and execution, using futures a company enters a hedge by buying or selling futures on the exchange. The market prices for the futures are transparent. You can observe futures prices in real time. The company pays a commission to the futures broker, which should be both modest relative to the notional value of the hedge and fully disclosed in advance of execution.
In contrast, with swaps the bank providing the swap acts as a principal and is the company’s counterparty to the swap. This creates the potential for misaligned incentives between the bank and company. The bank earns a profit on the trade by marking up the swap price to the customer over its cost to hedge itself in the futures market. The bank is motivated to widen this markup, as it is principal in the trade. Consequently, the company’s costs increase. The bank does not typically disclose the extent of this markup.
A level playing field
Another key difference is counterparty risk and margin requirements. When using futures, counterparty risk is mitigated. This is because a clearinghouse stands between buyers and sellers on the exchange. All users of the exchange post margin. Consequently any user of the exchange, from the largest and highest rated banks to smaller commercial enterprises can execute at the market price. In contrast, using futures there is no counterparty markup. Broker commissions, and fees for clearinghouse, NFA, and the exchange do apply.
In contrast, when using swaps both the company and the bank are exposed to each other’s risk of performance under the swap. For mid-market companies, this can sometimes mean that a bank is either unwilling to enter a swap. Alternatively, the bank will price it higher to account for the company’s perceived credit risk. The bank may also require the company to post cash or securities as margin.
Speak with the experts
Additionally, we suggest that you talk with your CPA firm for guidance on accounting treatment. Accounting treatment likely shouldn’t drive your strategy, but it is best to have a clear understanding on this aspect before executing.
At this stage you collect detailed information on the swaps or futures market instruments most germane to your needs. We suggest you start by speaking with your bank &/or a reputable futures market professional. The available futures hedging alternatives are straightforward, even if they are somewhat unfamiliar or confusing at first. Comparing the execution prices of interest rate swaps and futures market execution will help you clarify your path forward. Here at Kilo Futures, we would be grateful for the opportunity to explore this with you.
Step 3 – articulate your plan and obtain buy-in from stakeholders
A great interest rate hedging strategy is simple, flexible, and brief. Similarly, it should lay out the highlights of the analysis you completed in the steps above. It should also detail the key components of the plan, which should include:
- Establishing parameters fixed vs. floating interest rate exposure (e.g. company will have no more than 65% floating rate exposure, and not less than 40%)
- Which counterparties or futures contracts are acceptable for the company to deal with
- The horizon over which you will hedge
- An acknowledgement of the purpose of hedging (limit risk, not profit), and of the possibility that the hedge may result in an outcome where the company could have paid lower rates if it had not hedged (e.g. if you fix a greater portion of your rates and floating rates decline)
- Who in the company is responsible for executing hedges and monitoring that as the business evolves it stays within the established parameters
- Who will review the interest rate hedging policy and when
Determine who the key stakeholders are that need to be involved in approving and implementing the plan. Communicate your plan and seek buy-in or approval as appropriate. This isn’t a “CYA” exercise. The purpose is to ensure everyone understands and supports the strategy. Most importantly, it enforces rigor around hedging decisions and reduces the very human tendency to try to time markets. Critically, it helps avoid the very dangerous “I’ll hedge when rates drop” approach.
Step 4 – set-up, document, and execute
This step is more mechanical than analytical. There are some real differences in establishing a swap relationship compared to opening a hedging account with a futures provider. The agreements used to establish a futures trading relationship are relatively straightforward and standardized. The entire process of opening and documenting the account can take as little as a few days.
For swaps or other bank provided derivatives, the process can be a bit more involved. It often requires the bank to undertake a credit review process if you haven’t already established derivative lines with them. The governing document for swaps is typically the ISDA master agreement. Negotiating these documents can be time consuming and costly. Consequently, banks may only be willing to negotiate an ISDA with companies where the size of the swaps &/or the pricing provides sufficient profit incentive to the bank to justify the cost. Some banks do offer abbreviated, standardized documents which can speed up the process.
Executing your interest rate hedge should be a straightforward and quick process. You can do this by speaking with your bank’s derivatives representative or you futures professional. Here at Kilo Futures, in addition to your futures representative, you will also have access to an electronic portal. The portal allows you to execute hedges, see live market prices, and see real time mark-to-market information on your positions.
Step 5 – monitor, review and adjust
Monitoring and adjusting your exposures to align with your interest rate hedging strategy should occur periodically. Many companies review this along with their annual or quarterly budgeting process. Similarly, a review should also occur when your company has events like acquisitions, large capital expenditures, meaningful new borrowing, debt repayments, or refinancing.
We hope you’ve found this guide a practical and useful tool to help you evaluate and manage interest rate risk at your company. Please let us know if you have any suggestions on how we can improve it. Equally, if you would find it helpful to talk through your specific situation and explore the various interest rate hedging tools available to companies like yours, please contact us. We would be grateful for the chance to help.