Businesses need to consider how sensitive they are to potential future interest rate rises, with rates likely to increase further in 2022 as the Bank of England looks to manage rapidly rising inflation.
In this article we will outline the main ways companies can hedge interest rates, in order to mitigate the impact of those rate rises. The article will also look at some of the key pros and cons of each of these strategies.
Interest rate hedging decisions tend to be long term, so care must be taken when deciding which options to use. History has shown that the direction of short-term interest rate movements can easily change within the life of the chosen option used to hedge interest rates (e.g. due to changes in economic policy and unforeseen UK / world events).
Fixed rate loans
A borrower could choose to manage interest rate risk by having a fixed rate loan.
With a fixed rate loan, regardless of movements in the Bank of England base rate (the “Base Rate”), the interest rate of the loan would be unchanged. Here the lender is either hedging the interest rate risk themselves or paying a fixed return to their investors.
However, only considering a fixed rate loan will reduce the number of funding options available and may result in a higher overall funding cost (compared to floating rate funding options).
Interest rate swaps
Interest rate swaps are one of the most used options for interest rate hedging, with around 90% of interest rate hedges entered into with UK banks using swaps.
An interest rate swap is a type of contract that is linked to a loan agreement but separate to the actual loan. In an interest rate swap, for the duration of the loan the floating rate part of the interest rate is swapped for a fixed rate. This would lock in the interest rate payable, regardless of future movements in the base interest rate.
The swap interest rate is typically higher than the prevailing Base Rate, particularly if, at the point the contract is entered into, interest rates are expected to rise over the term of the swap.
It is worth noting that if a business wants to cancel a swap, there could be substantial break fees payable if the prevailing Base Rate is lower than the agreed swap rate. In this eventuality, the longer the remaining term on the swap, the higher the potential break costs would be.
Interest rate caps
An interest rate cap is a contract (again separate to a loan agreement) that acts to limit increases to the floating interest rate to an agreed maximum level (the “Cap”).
For a borrower with an interest rate above the Bank of England’s benchmark Sterling Overnight Index Average (SONIA) rate, the SONIA rate would be payable until the rate rises above the Cap.
For example, if a company buys an interest rate cap at 1% and the monthly SONIA rate was 0.5%, the company would pay an interest rate based on the prevailing SONIA level of 0.5%. However, if the SONIA rate was 1.3%, the company would pay interest based on the effective maximum rate of 1%. The cost of buying a cap (the “Premium”) typically needs to be paid upfront. In that respect, buying a cap is similar to paying an insurance premium, as it protects the business against increases in the Base Rate / Sonia above the Cap level.
Interest rate collars
Interest rate collars are contracts which limit fluctuations in the effective SONIA rate to between agreed minimum (the “Floor”) and maximum (Cap) levels.
Buying a collar, which involves buying a Cap and selling a Floor in a single contract, tends to be cheaper than the cost of buying an interest cap since the minimum rate payable under the contract could be higher than the prevalent SONIA rate.
For example, if SONIA was 0.5% but the agreed minimum rate was 0.75% under the collar contract, the interest rate for the loan would be calculated based on the effective minimum rate of 0.75%.
It is often possible to set the Floor level at an interest rate high enough to fully eliminate the Premium cost of the Cap part of the contract (a “zero cost collar”).
How advisers can help
Advisers play an important role in evaluating debt funding considerations. Advisers’ expertise and connections to funders can guide businesses through the funding process. They will know who to contact and what information is needed. Whilst the decision on which hedging option, if any, is most appropriate is typically for each client to make independently, advisers can work with regulated counterparties to help companies to evaluate the available options.
ACP Altenburg Advisory works with business throughout the entire funding process. Firstly, establishing the need to haves and the nice to haves from a funding solution. Working back from these ACP Altenburg Advisory will help to develop and structure the most appropriate funding solution. ACP Altenburg Advisory will then help source, review, and negotiate funding offers to help the business implement the most appropriate solution.
ACP Altenburg Advisory is part of ACP, a leading independent debt advisory association for SME and mid-market companies, advising clients on the options available to them and providing hands on support from day one all the way through to drawdown.
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