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.

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. 

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.

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