After a decade of interest rates near zero, many corporations have opted not to manage, or even consider managing, their interest rate exposure. That philosophy could soon change, either by choice or dictated by market imposed volatility. In mid-June, in announcing its third quarter-point rate increase in the past six months, the Federal Reserve was making it clear — it is not business as usual. In fact, various market participants are now forecasting one more hike in 2017, and for the upward trend to continue beyond this year.
On Jan. 18, in a speech to the Commonwealth Club in San Francisco, Federal Reserve Chair Janet Yellen stated: “[We are] expecting to increase our federal funds rate target a few times a year until, by the end of 2019, it is close to our estimate of its longer-run neutral rate of 3%."
Given this outlook, today’s treasurers have reason to do something they may never have felt pressed to do before: develop an interest rate protection plan.
With the hikes of the past six months amounting to a 75 basis point move, financing costs for variable rate obligations are rising, and if the Fed’s projected additional hikes occur, companies with interest rate exposure will experience further increases in financing costs. A customized hedging strategy could protect the bottom line.
“Any organization that has outstanding debt or projected outstanding debt — and whose profitability is susceptible to changes in interest rates — should have an interest rate protection strategy,” advises Bob Tull, Managing Director and Global Head, Financial Risk Management, at Fifth Third Bank.
The timing of implementing a hedging strategy is critical. Now, with rate hikes in December, March and June behind us and more looming, this is the optimum time to act, Tull says. “If you wait for the volatility to set in, that’s the most expensive time to execute the hedge. The last time the Federal Reserve raised rates twice in three months was in 2004, the beginning of 425 basis points of rate hikes over two years. Borrowers waiting for a sign that the trend upward has begun may have just gotten it.”
Developing a plan
Your Fifth Third Relationship Manager, in conjunction with your Financial Risk Management professional, can assist you with your interest rate management needs. To determine those needs, companies may take the following steps:
Understand exposure. Companies may start by forecasting the financial impact on their business as interest rates rise. Given their existing debt and projected outstanding debt, coupled with the financing options the company is using today or considering for the future, what will be the impact as rates increase over the short and long term?
Evaluate your risk appetite. Before campanies can make any decisions about hedging interest rates, they need a clear understanding of their risk tolerance. In other words, how much floating-rate exposure are they comfortable with? Risk tolerance can be impacted by a number of factors:
- The company’s debt levels
- The consistency or seasonality of cash flows
- The company’s competitive position in the marketplace
- The company’s responsibilities to investors and shareholders, and criteria for meeting certain Earnings Per Share (EPS) or margin forecasts
Risk appetite and risk factors can vary significantly from company to company. Based on a company’s risk tolerance, it might be comfortable with 100% floating-rate exposure, or feel compelled to hedge a majority of that exposure.
Develop a specific strategy. Once a company’s exposure has been identified and there is clarity regarding its risk appetite, the company may decide interest rate protection, for some portion of its debt, is the right decision for the business. At this point the company can begin to investigate specific tools and approaches. Interest rate protection tools can range from common products such as interest rate swaps, caps and collars to more tailor-made strategies. The strategy, like the decision, needs to be developed with the company's risk tolerance being the driver.
A holistic approach to managing financial risk
The most effective approach for a company is to review its financial risks in a holistic manner. Interest rate risk is but one of the financial risks a company may be facing. Other important risks are foreign exchange risk and commodity price risk. If a company is importing or exporting — even if in U.S. dollars – it is subject to indirect foreign exchange risks. If a company has commodity inputs into the manufacturing or distribution of its goods or service, it will have commodity exposure. Profitability could be impacted by volatility in any of these areas and, similar to interest rates, the risks should be identified, analyzed and discussed to determine if, and how, the risk can be managed.
Managing both direct and indirect risks can create a competitive advantage for business, Tull suggests. “The market is dynamic and interconnected. Thus, a move in interest rates will affect commodity prices and currency rates. While the moves may appear subtle, the effect on your business can be like an 'undertow' in the ocean – knowing it is there, and its potential impact, is half the battle.”
To start a conversation about all of the financial risks your company faces, and how you can protect your bottom line in the face of those risks, ask your Relationship Manager to connect you with a Fifth Third Financial Risk Management specialist.