No company with variable rate debt
can afford to ignore its exposure to
interest rate fluctuations. An effective interest rate strategy enables a business to
better manage its exposure to unpredictable market conditions over the term
of a financing and more accurately budget
future interest rate expense.
Smart Business asked Guy Kossuth, vice
president and managing director of PNC
Capital Markets LLC, to illustrate how
companies can reduce their interest rate
risk and develop an optimal interest rate
hedging strategy.
Why do companies need an interest rate
hedging strategy?
Most companies have a good understanding of their financing needs. But once
they have the capital structure in place,
whether it is a term loan or revolving credit facility or a combination of both, they
need to think about how they manage their
interest rate exposure over the life of the
loan. Since senior debt is funded largely on
a variable rate basis, the tendency is usually to focus on the current variable borrowing rate, not on how these rates are anticipated to move over time. This can expose
a company’s balance sheet to undue risk,
especially if debt market conditions
become volatile. Moving from a floating to
a fixed interest rate enables a business to
take some of the variability out of the equation because interest expense then effectively becomes an anticipated fixed line
item for budgeting purposes.
What solutions are available?
Interest rate protection strategies are
extremely flexible and can be customized
specifically for a company’s debt profile
and tailored to its risk management objectives. The most common solutions include:
- Fixed rate swaps: An interest rate
swap is a contractual agreement in which
two counterparties agree to exchange
interest payments at different rates
through a stated maturity date. Swaps offer
extremely flexible terms and are highly
customizable, allowing a borrower to effectively convert a floating rate to a fixed
rate, or vice versa. - Interest rate cap: A cap is an agreement that limits a company’s floating interest rate exposure to a specified maximum
level for a specified period of time. In
essence, a cap is an insurance policy purchased by a business to protect itself
against rising interest rates. Unlike a ‘collar’ there is no minimum rate specified. - Interest rate collar: A collar provides a company with a floating interest
rate range between a ‘ceiling’ and a ‘floor’
level.
How can companies manage their interest
rate risk?
Executives need to determine their tolerance for interest rate risk and how much
exposure their business can sustain on the
liability side of the balance sheet. They also
need to take a long-range view. A business
may be enjoying the benefits of extremely
low floating rates and hope that rates will
remain stable for the foreseeable future —
but there are no guarantees.
It is also important to consider future
plans, especially if they include an acquisition, a spin-off of existing operations, a
restructuring or recapitalization. It may be advantageous to think about an interest
rate strategy in the planning stage of the
refinancing, especially if the current interest rate environment is potentially more
attractive than is forecasted at the time the
financing is targeted to close. Finally, executives need to revisit their interest rate
hedging strategy periodically and make
adjustments based on their company’s
changing needs and market conditions.
How do you determine what risk strategy
makes sense for your company?
Some companies are in a better position
to tolerate risk than others. A paper manufacturer with low profit margins and high
capital expenses may be extremely sensitive to interest rate increases, especially if
it is unable to pass on its higher costs to its
customers. In contrast, a specialized technology company with greater pricing
power might be less sensitive to market
fluctuations because it has greater flexibility to manage the revenue side of the equation over the term of the financing.
Ultimately, every company needs to be
comfortable with its level of interest rate
exposure. Markets are inherently volatile,
so executives need to take a long-term
view, recognizing that while they may not
‘lock in’ a fixed rate at the lowest point, a
well-conceived strategy will help a company to better plan its interest rate expense
management and may even save money.
To learn more, check out PNC’s
Middle Market Advisory Series at
www.pnc.com/go/derivatives.
This article was prepared for general
information purposes only. Under no circumstances should any information contained herein be used or considered as an
offer or a solicitation of an offer to participate in any particular transaction or
strategy. The information herein does not
constitute legal, tax or accounting advice.
Opinions expressed here are subject to
change without notice. PNC Capital
Markets LLC is a registered broker-dealer
and a member of SIPC and NASD.
GUY KOSSUTH is vice president and managing director of
PNC Capital Markets LLC. Reach him at (412) 768-7977.