Hedging during COVID-19
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Hedging Rate Risk in the Time of COVID-19

This is a time of great uncertainty and understandably, the most pressing concern for many firms is to retain cash and maintain solvency. But for those businesses with the capacity to take a longer-term view, the collapse in forward expectations for interest rates presents borrowers with an opportunity to hedge long term interest rate risk on their loans at historically low rates, improve cash flow visibility and maybe even insulate their firms from a future Black Swan.

How do current hedge prices compare with historic floating rates?

Historic and future interest
Hedging Rate Risk in the Time of COVID-19 4

Introduced by the major Central Banks to counter the Global Financial Crisis (GFC) in 2008, the combination of ultra-low rates  and unconventional monetary policy initiatives were supposed to be temporary but, 10 years on, borrowers continue to benefit from historically low borrowing costs (fig.1-blue columns). Yet, the latest forward curves for GBP, EUR and USD rates are mapping future expectations for rates (fig 1-green columns) that are even lower again-and in the case of US 3- and 5-year fixed rates, by some distance. The most common rationale for hedging is that it provides certainty for financing, planning, and budgeting but hedging interest rate risk with an Interest Rate Cap, Swap or other derivative now comes with the additional bonus of achieving this certainty priced off historically cheap levels.

Is Inflation the next Black Swan?

But hedging interest rate risk may also provide a further benefit, it can also protect your firm against what could well be a future Black Swan: inflation. Black Swans are low probability events that, if they occur, have a disproportionate impact on the economy. And Black Swans seem to be happening with increasing regularity. Seismic events that fit into this category are the 2008 Financial Crisis which introduced negative rates in Europe and Quantitative Easing to the world; the Brexit vote which saw sterling fall 12c the day after the EU referendum vote; and the current COVID-19 pandemic which has directly resulted in US unemployment soaring by over 20 million in the month of April alone and real concerns that GDP in most advanced economies may fall by more than 20% in Q2

It has been decades though since persistent inflation has been a problem for Western economies. However, recent articles in the Financial Times and Bloomberg highlight not only the potential for upward pressure on prices coming from a post lockdown spike in consumer demand and reshoring of supply chains but also argue that not only would higher inflation be welcome but that it should also become official central bank policy.

Globally, excess debt levels throughout all sectors of society are a significant and growing problem. UK government Debt/GDP is expected to breach 100% this year- its highest levels since the early ‘60s; US non-mortgage household debt is almost $1.5 trillion higher than its peak during the last crisis in 2008; and zombie companies- those firms that are not generating enough revenue to service loan commitments-were estimated to number about 15% of businesses in the US and Europe even before COVID-19 struck. However, with interest rates close to zero, Central Bank balance sheets bloated and government debt ballooning, the range of fiscal and monetary policy levers available to the authorities to pull to ward off future crises are narrowing.

Not all heroes wear capes

The good news is that using inflation to reduce the burden of debt has previous form. By running inflation at 7%, the USA successfully used inflation to get its post-war debt burden under control. Expectations are that it would only take a smaller rise in the inflation target from 2% to 4% or 5%, to enable governments, businesses, and households to collectively reduce the quantum of their debts to more manageable levels today.

In the short term, it’s unlikely that the Federal Reserve and other central banks will formally increase their inflation targets from 1-2% to 4% if for no other reason than they risk losing credibility if their higher target isn’t hit. A real possibility given that central banks have been more pre-occupied with the threat of deflation since 2008.  But as a longer-term solution to the debt burden, inflation would be welcome, and it is difficult to see how a secular rise in inflation could happen independent of a rise in rates or at least forward expectations for rates, which drives the cost of hedging.

What should I do- float, fix or Cap?

Without a doubt, these are extraordinary times. The data to be released over the coming weeks will confirm that the economic slowdown this quarter will surpass the numbers seen in the crash of 2008. But what direction does the economy take after that? A sharp V shaped recovery? A long deep recession that surpasses the 2008 GFC? Or, something in between?

Businesses are facing any number of business risks now with little, if any, visibility around costs or revenues. Fortunately, some financial risks, like the cash flow risk on term debt can be controlled. Borrowers with a strong view that interest rates are going to stay low, maybe move into negative territory (further, for euros) may prefer the flexibility provided by floating. In the current environment, others may prefer to sacrifice flexibility for the visibility that a fixed and certain cost of borrowing at historical lows provides.

Interest Rate Caps provide a viable alternative. Rarely used before 2008, Caps have become increasingly popular in the past decade. Although more complex to price and understand, there are inherently more conservative than either fixing or floating as a Cap simultaneously controls your cost of borrowing and provides flexibility. Flexibility not only in terms of your ability to benefit from low interest rates but also to look outside of your lender to source a cheaper hedge provider in the broader market.

Whatever you do, now more than ever, it’s vital that you take the time to make an informed decision about the financial risks within your business. With multi-decade experience of the financial markets, the team at Vuca Treasury are here and ready to provide the insight you need to make those calls.

Interest rate swap vs interest rate cap

Over the last decade, interest rate caps were a popular product to protect against rising rates. However, throughout 2022 the premium has risen substantially. Firms are now switching to interest rate swaps (fixed rates). Given the credit risk, the majority of swaps are conducted directly with the lender, leaving no room for price tension. VUCA’s team of ex-bankers can calculate the true cost of a swap. Contact us today or schedule a call back below to find out more

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