Companies that used interest rate derivatives to lock in low borrowing costs on their loans when rates were near zero are looking at how they can monetise these hedges now that they have increased significantly in value.
Central banks' aggressive tightening of monetary policy in a bid to lower inflation has pushed US dollar 10-year interest rate swap rates to 4.2% from 0.5% four years ago, presenting an opportunity for corporate treasurers who fixed their loan payments at historically low levels.
Agreeing with their bank counterparty to unwind or restrike some of their derivatives hedges could release money for companies that they can then use to lower the cost of new hedges now borrowing costs have risen.
Jackie Bowie, head of EMEA at consultancy Chatham Financial, said there has been a “material” increase in requests from corporates looking to take advantage of the “hundreds of millions of dollars” of value in these derivatives positions.
“If corporate borrowers had already put interest rate hedges in place back in 2021 or earlier, then those hedges would be in the money with a significant value to the borrower,” Bowie said.
Monetising hedges
One common way for corporates to monetise the value of derivatives is to pay a fee to their bank counterparty to renegotiate the hedge to a slightly higher rate of interest, allowing them to unlock some of the cash value of their original hedge in the process.
If a corporate had previously locked in a 1% rate of interest on its borrowing costs for the next two years, but market interest rates increase to 4%, they could try to agree with their bank to "blend and extend" their hedge for another two years at 2.5%. Such strategies have the advantage of avoiding a big step-up in funding costs for the corporate when the original hedge expires.
However, agreeing to lock in a new rate can be tricky for corporate treasurers. Some may be nervous about the future trajectory of interest rates with inflation remaining stickier than economists had expected. Loan covenants can also pose hurdles – with highly indebted companies typically required to hedge their interest rate risk as a prerequisite for securing a loan.
Covenants can, for instance, sometimes prevent corporates from attempting to blend and extend their hedges to a higher rate of interest. Corporates putting on entirely new interest rate derivatives could also face issues if they are using a different type of hedging instrument.
“There’s limited appetite from lenders to renegotiate covenants or hedging requirements just to allow counterparties to extract value out of their derivatives,” said Emma Greenlees, director of financing and risk solutions in NatWest Markets’ commercial and institutional franchise. “That’s why every solution I’ve discussed with a corporate looking to negotiate their in-the-money hedges has always been rooted within the parameters of the loan agreements they already have.”
Debt mix
The rise in interest rates is also encouraging corporates to reconsider how they manage interest rate risk across their debt pile more broadly. Historically, many companies would peg about 40% of debt to a fixed interest rate and leave the rest floating. That has changed in the past decade when interest rates reached near zero, with many opting to fix as much as 90% of their borrowing costs.
Corporates keen on ensuring stable borrowing costs have often retained that same fixed-to-floating mix even as central banks have hiked interest rates. However, now that more central banks have signalled that they’re ready to start loosening monetary policy, corporates are debating whether they should shift to a higher proportion of floating-rate debt.
Fixed-to-floating debt rebalancing has been a "big driver of activity this year," said Ashley Parker, head of corporate solution sales for EMEA at BNP Paribas. Typically, this has been achieved by clients unwinding their fixed-rate hedges or swapping new fixed bonds to a floating rate of interest, he said.
While such a decision will depend on many factors, a company's leverage is key. "If you’re a high-yield borrower, you may not be able to absorb fluctuations in interest rates as well as your investment-grade counterparts, and therefore you may want to keep a higher portion of fixed debt to reduce uncertainty around your future cost of interest,” said Parker.
