Farah Lotia is the Director, Interest Rate and Quantitative Analytics at Hedge Trackers

Corporate exposure to interest rate (IR) risk will become increasingly consequential as rates continue to rise following the long period of historically low borrowing costs and investment returns. The rate changes mean that more CFO offices, corporate treasurers and accounting teams must strategically optimize their debt and investments by putting IR hedge programs into place. For some, this will mean dispelling a historical reluctance to do so.

First, a definition: IR hedge programs enable organizations to exchange variable-rate debt for fixed-rate debt (or vice versa), shifting to more acceptable risk. Netting variable interest income with variable interest expense and other natural offsets are available as volatility-reducing tactics, as are derivatives that limit the risks associated with current balances and future exposures.

By leveraging these tactics, IR hedge programs offer a valuable form of risk mitigation as interest rates, FX rates, oil prices, and inflation continue to rise.

Overcoming reluctance

While current circumstances support the strategy that there has perhaps been no better time over the past several years than now to implement an IR hedge program, many treasury teams have been on the sidelines for either conceptual or logistical reasons.

Those hung up on buying into IR hedging as a concept are often concerned with the cost, and begin to analyze an IR hedge program strategy in terms of the gains and losses once derivatives are settled. This approach doesn’t put hedging in its best light – but it also misses the point. Hedging should be thought of as a form of insurance. It exists to protect treasurers from both rate increases and financing cost variability. When rates fall again, the hedged derivative payments offset debt savings, ultimately eliminating risk exposure and achieving a known fixed debt cost. As an analog for insurance, the analysis shouldn’t compare insurance payouts to premium costs, but rather the total risk mitigation that carrying insurance enables. In fact, treasurers just coming into this concept have already missed out on some opportunity for protection, as the market now already accounts for some anticipated rate shifts. But IR hedging still offers tremendous advantages for treasurers that understand its real costs and benefits, and the best time to begin is today.

From a logistical perspective, some treasurers have balked at the perceived challenge of launching an IR hedge program given the seemingly black-box nature of derivatives. Derivatives are primarily exchanged in over-the-counter trades, with no easy-access public database available to assess reasonable transaction costs, execution spread, or other valuable data. Treasurers also need to identify natural hedges in their portfolios, and make accurate decisions as to how to evaluate and engage with banks, how many of these relationships to maintain, how to best diversify counterparty risk, how to build a best-in-class ISDA for their credit profile and industry, and more. While establishing IR hedge program best practices and controls do take some effort, the rewards are well worth it both near-term and for future uncertainty.

Strategizing around IR hedge costs and duration

Given the logistics challenges that many corporates encounter when launching IR hedge programs, hedging costs and durations come in many shapes and sizes. They are particularly dependent on industry and type of business. From a broad perspective, most hedging is at a five-to-seven-year duration. However, the anticipated inflation pressures extend the high end of that range.

Reference rate reform is another significant factor, with corporate adoption of Term SOFR and overnight indexed SOFR driving broader liquidity spreads. Further adaptation is needed to transition existing hedges and anticipate hidden fallback costs, especially in the U.S. market. That said, the far greater transparency these shifts bring to the market benefits treasurers when it comes to simplifying and improving decision-making accuracy.

From a strategic perspective, a corporate treasurer I was recently speaking with from Wilbur-Ellis approached IR hedging by emphasizing timely execution and market transparency. By hedging exposure in March 2020 – well before current rate increases and inflationary pressures emerged as factors – the company has locked in a sub 1% hedged interest rate through this decade. However, that projected monetary net gain versus un-hedged rates isn’t the most significant effect of their IR hedge strategy. The treasury team’s complete immunity to IR risk and predictable exposure relative to debt issuance represents the clearest advantages.

Those gains stem from a clear-eyed analysis of the true costs and benefits of hedging and clear communication of those benefits across all corporate stakeholders. That analysis and market visibility enabled optimization of pricing outcomes and execution costs. Wilbur-Ellis entered multiple swaps simultaneously across pooled counterparties, diversifying exposure while negotiating competitive ISDA terms and trading costs. As a result, the treasury team was able to reduce costs by several basis points and, more importantly, maintain its risk appetite to raise capital at favorable terms going forward.

The time to hedge is now

Implementing an IR hedge program requires careful preparation to recognize clear risk management policy objectives and specific strategic hedging opportunities. Treasury teams that execute a well-prepared and tailored hedging strategy will command clear advantages when it comes to mitigating increasing risk in the emerging monetary environment – and the sooner the better.