The past few years have seen significant volatility in interest rate markets and, as a result, similar variability in borrowers’ cost of capital. The Federal Reserve cut floating rates to near zero in the wake of the pandemic, pulling fixed rates like the 2-, 5- and 10-year Treasuries to their lowest levels ever in the process. Two years later, the Fed embarked on its most aggressive rate hiking cycle in history, increasing their target rate by over 5% since March 2022, while long-term fixed rates increased to levels not seen since before the global financial crisis of 2007-2009.[1] Most recently, short-term floating rates have exceeded long-term fixed rates—a relatively unusual phenomenon referred to as an inverted yield curve.

With so much uncertainty about the future direction of floating and fixed rates, borrowers may consider adopting strategies to help manage interest rate risk and potentially capitalize on the unique aspects of the current environment.

Hedging Strategies

According to Adam Goff, Managing Director in PNC’s Derivative Products Group, one of the benefits of working with rate hedging products is the ability to adjust the hedge to the particular needs of a borrower or a project. “When the rate environment changes or a borrower wants to address a specific risk, targeted strategies can help manage risk within the unique aspects of the landscape.” Goff said. There are several hedge structures that borrowers may want to consider in the current environment.

  • Forward-starting interest rate swaps: Similar to a traditional interest rate swap, a borrower agrees to pay a fixed rate in exchange for receiving a floating rate. However, with a forward-starting swap, the fixed rate is calculated and set today, but the bank and the borrower delay the exchange of the interest payments until a future date. Forward hedges are growing in popularity due to continued uncertainty about where fixed rates might be when a borrower is ready to term out or issue debt, as well as to the inverted yield curve. Forward-starting swaps are commonly used in loans that include an initial draw period or to manage the interest rate risk on forecasted debt.
  • Interest rate collars: A zero-cost interest rate collar may be another attractive option to hedge interest rate risk as uncertainty grows around the direction of floating rates. A collar sets a maximum and minimum rate for a floating index like the Secured Overnight Financing Rate (SOFR), and within that range, the borrower pays the floating rate.
  • Cross-currency interest rate swaps:  As the cost of borrowing in the U.S. has increased, borrowing in foreign currencies might have a comparative advantage for companies with international revenues or operations. Cross-currency interest rate swaps, which are agreements between two parties to exchange interest payments in two different currencies, may provide an efficient way to gain exposure to foreign interest rates. Most often, borrowers use cross-currency swaps to redenominate U.S. dollar debt to a foreign currency. It may be an effective hedging structure when the borrower is confident in their ability to generate cash flow in the foreign currency.

Customized Approach to Implementing Hedging Strategies

In terms of how borrowers are choosing to deploy their hedging strategies, Goff noted that there is a trend toward balancing interest rate protection with some capital structure flexibility. “Borrowers may choose to implement smaller, incremental hedge amounts executed over a broader timeline, rather than take an all-in approach that locks in a fixed rate on the fully borrowed amount on a single day,” Goff said, adding that these hedging strategies may take the form of layering smaller tranches, laddering/staggered maturities, or partial hedges.

“There isn’t necessarily a right or a wrong way to position your debt mix, more of a range that’s likely to be reasonable depending on the goals of the organization,” said Goff. “Instead of trying to guess where rates might be going, a better approach may be to implement a capital structure and hedging plan that provides the right balance of protection, liquidity, and flexibility, regardless of the outcome of the long list of variables that can impact the cost of capital.”

Ready to Help 

PNC’s Derivative Products Group can work with you to implement a capital structure and hedging plan that provides the right balance of protection, liquidity, and flexibility. Click here or contact your relationship manager to arrange a meeting with a Derivative Products Group Marketer to learn more.