From the September/October 2012 issue of Treasury & Risk magazine

Interest Rate Hedges

Market intelligence, Trade Analysis, and Regulatory Change

Multiple factors affect decisions on mitigating interest rate risk. In the current market environment, understanding these many factors is challenging but the need to manage them is also more critical. To help you map a successful strategy, Christian Miller, Senior Fixed Income Markets Specialist at Bloomberg, explains how to interpret interest rate trends and analyze forecasts to make better informed hedging decisions.

The current environment is a bit of a gut check in that it differs significantly from market conditions in past years. Treasury yields are at historic lows. The yield curve has recently flattened fairly dramatically, making it harder to exploit a steep yield curve. Recovery could take longer than expected and political risk is extremely high.

But business must go on, to borrow a phrase from Hollywood, despite the challenges. And there are ways to proceed in an informed and strategic manner and find opportunities.

For one thing, forward rates can be a signal of future rates. How steep the yield curve is indicates how much the market is pricing in higher rates in the future. You can look at the forward curve and see what is priced in currently.

As to recovery uncertainty, if the rates stay low for longer than the market is currently pricing in, then you could benefit from strategies that take advantage of higher rates that are priced into the curve which may not come to take place as time goes on.

Perhaps the biggest wild card is political risk. During election year, job stimulus and market growth will be key goals for the current administration. However, the race is extremely tight and the likely outcome is almost impossible to predict. Implementation of regulations and requirements could vary significantly depending on who wins the general election. There is also a need to closely watch the impending January 2013 fiscal cliff and how the current and the new Congresses choose to deal with it. Overall, this is a very fluid situation that bears close scrutiny.

To get a picture of where we are now, consider quarterly 10-year bond yields going back to the 1960s. We are currently down around 1.5 percent, the historically lowest levels in the past half century. That is a boon for anyone wanting to borrow in the long end of their curve but there is also the question of whether that will continue and if in fact rates may drop even lower.

The same thing is seen in the swap market which is really just a spread to the treasury market. The current 1.6 percent in 10 year swap yields is low for the year and also among the lowest in the past 50 years or so. 

One indication of how steep the curve is can be found in a cross view of the 10 year swap yield versus the actual floating spread which is what is used in a swap, the three month LIBOR rate. The three month LIBOR rate has been very low for a very long time while the 10 year swap rate has bounced around more. The spread between those two things shows the curve has flattened into about a 115 basis points or so from a high of 300 almost 400 basis points from a year or two ago. This is a very dramatic flattening and it does change some of the dynamics on available hedges and what that means for the economics for them.

An examination of what economists are currently thinking sheds some further light on the issues. The biggest takeaway is that no one is thinking that the Fed funds rate is going up; it’s pretty much stuck at 25 basis points and in fact the Fed has announced that is where they want to keep it through 2014. LIBOR is also holding steady at 45-60 basis points as we move out over time. But there are expectations for the 10-year rate to go up from the current rate of 150 to a predicted high of 265 by the end of next year. So there are opinions that there will be a steeper yield curve in the future.

Another indication is market implied forward curves. For example, one year forward rates on coupon swaps are about 25 basis points higher than the current spot rate of about 161. That is a general indication of the steepness of the curve and how much rates are implied to rise in the future. These things change over time and it’s something to keep in mind when considering hedges. It’s telling you how much more expensive it may be in the future to hedge, to lock in a fixed rate, than it would be right now.

All of which leads to the ultimate question of whether implied forward rates actually predict the future. There is a way to back-test the accuracy of these in regards to their predictions. For example, looking at implied forward rates from a year ago and plotting them against what actually came to pass. Such an examination shows that the predictions made a year ago missed what actually happened by an astonishing 200 basis points. That’s a lot of opportunity lost a year ago when locking in rates because rates have moved much lower.

In fact, if you go back to any period in history, what is priced in never comes to pass. Either markets will stay lower or rise higher than predicted. Especially when the Fed goes into a tightening mode, the forward curve tends to under-predict how much the Fed may actually tighten. This is something to keep firmly in mind when using forwards in hedge determinations.

To sum up current market conditions: rates are low but expected to rise and the yield curve implies but does not guarantee higher rates. The implications to your bottom line depend on how exactly you are exposed and your opportunity cost or risk does too. That said, there are a number of ways to respond to opportunity and risk now.

A good beginning is to consider the fixed to floating mix. Look at the liability-term structure and determine when principal payments are coming due, i.e. at what points of the yield curve borrowing was done. You can then move duration in or out depending on your market view, the shape of the yield curve, access to funding, and other issues in the debt issuance market.

Moving rates does create an interest rate risk. For example, fixed-rate bond issuance might lock in a higher long-term rate in a steep yield curve environment so you might want to pay a floating rate instead. However, floating-rate loans expose a company to higher costs if LIBOR rates go up in the future so you may prefer to lock into a fixed rate. Plans for future borrowing may expose you further to interest rate fluctuations between now and the time of issuance so you may want to opt to protect against that by locking in rates now.

You may benefit from a swap in one or more of your debt repayment scenarios. A swap is an exchange of streams of payments over time according to specified terms. Usually companies swap from fixed to floating and the float is periodically reset off some defined index such as three-month LIBOR.

The important definitions to remember are that coupon means a fixed rate; spread is the constant number of bps over floating rate; market value is the value of swap at a given time; and DV01 is the change in market value when the underlying curve moves by one basis point.

Another way to think about this trade is in terms of what the cash flow looks like. You can used fixed rate to prevent any jump in payments or potentially use a floating rate to reduce payments for part or all of the repayment period to increase cash flow.

Certainly no one would make a swap deal with you for a floating rate if LIBOR was not expected to rise over time; however, if rates do not rise as predicted you could indeed pay less for the debt than with a fixed rate. For example, if the Fed funds rate holds for another year or two, which it certainly might, a floating rate could be substantially lower than a fixed rate.

Swap rates are just a spread to treasuries. The treasury market is the most liquid thing out there. Swap spreads are just a spread over benchmark treasury rates so a 10 year swap rate would be something like 10 year treasury rates plus 10 or 12 basis points. And, that 10 or 12 basis points are what swap traders think about. That is the risk they are trying to manage.

In summary, interest rate swaps are used to transform cash flows from fixed to floating or vice versa. Swap rates trade as a spread to government bonds and they imply expectations about the future path of a three month LIBOR (or the floating rate). The decision to use a swap depends on what you want to accomplish.

Specific hedging strategies include treasury rate locks, forward starting swaps, and interest rate caps and floors.

The advantages of treasury rate locks are that they are inexpensive, hedge against rate risk, are easy to understand, and they are very liquid. The disadvantages are that they don’t hedge against spread risk, they can’t match cash flows exactly, it’s harder to hedge the curve, and there is no hedge against volatility.

Forward starting swaps hedge rate and spread risk, match cash flows exactly, and hedge the curve. However, they are more expensive, do not hedge volatility, and become less transparent the more they are customized.

Interest rate caps, such as a LIBOR cap, on floating rates hedges volatility. They can match cash flows, hedge spread and curve risk, and you can customize it. However, caps can be a less liquid hedge, its more expensive and complex, and you have to pay some cash upfront in a premium.

Regulations must also be figured into the risk model. For example, under Dodd Frank, rules govern the market maker, the dealer, profits made, and the swaps business in general. 

Swap dealers must report their position and price data as well as clear swaps and execute on an exchange. Further, they must keep daily records of email, phone and instant messages related to transactions. They must also set aside initial margin at the onset and variation margin throughout the life of the contract. Capital must be posted. They also have to register with the Commodities Futures Trading Commission or the Securities and Exchange Commission.

Qualified end-users are exempted from central clearing and exchange trading. However, specific certifications, approvals, and reporting practices are required.

While such regulation is designed to insulate counterparty risk, it also affects the valuation of outstanding swaps.

The credit crisis and subsequent regulation, such as Dodd Frank and Basel III, make it more expensive for banks to trade swaps. Credit risk must be fully accounted for; and, pricing and mark–to-market levels will vary more due to different ways of accounting for credit risk and discounting future cash flows.

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