Hedging in an inverted yield curve environment
- July 10, 2019
Today’s inverted yield curve creates a unique situation for companies considering whether to hedge their floating rate debt.
Today’s inverted yield curve creates a unique situation for companies considering whether to hedge their floating-rate debt. In any market environment, hedging can improve consistency and reduce variability in interest expense. Determining whether to hedge with an interest rate swap typically involved weighing the desire for certainty within interest expense against the cost to achieve that certainty. In today’s environment, however, companies can not only create certainty in their interest expense but also lock in a swap rate that is lower than where short-term rates are fixing.
Interest rate swaps entail exchanging the fixed or floating payments of interest expense faced on debt for the opposite, in order to reduce or increase exposure to fluctuations in rates. The fixed rate is set based on the forward curve and, because of where swap rates price along the forward curve, the relative cost to swap longer tenors is much more favorable than in previous years and this dynamic can lead to short-term interest savings.
The yield curve is inverted as a result of market participants expecting short-term rates to be lower in the future than where they are today. Indeed, the market is currently pricing in between two and three rate cuts from the Federal Reserve before the end of the year, which is reflected in the shape of the USD LIBOR forward curve (see above). In the above example, if rates were to follow the forward curve, the hedging company would be a net receiver of cash flows during the initial periods, representing a true interest expense pickup. In dollar terms, if a company has a $100 million swap, with a fixed rate of 1.75%, they would net receive roughly $125,000 between now and the end of 2019. Notably, if the Fed does not cut rates as fast or as far as the market expects, the pickup would be even greater. If rates were to continue to stay at projected low levels in future years, however, the company would be net paying on the swap during those future periods.
Amid the uncertainty of future interest rate movements, scenario analysis can prove useful when considering hedge ratios, tenors, and products. Before entering into such a trade, it is important to quantify the impact of a market surprise in either direction. Additionally, while an interest rate swap can be a valuable tool for companies to synthetically create fixed-rate debt, there are several additional activities organizations should undertake before locking in such a contract. These include assessing counterparty credit charges, measuring potential breakage of a swap liability, understanding future debt capital structure, and ensuring efficient trade execution.
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Chatham Financial Corporate Treasury Advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.19-0185