After working through numerous interest rate cycles, the last 90 days has vexed many market participants and borrowers. For the most part, the Federal Open Market Committee (FOMC) has delivered relatively predictable rate increases and decreases over the last 20 years, with few exceptions. Likewise, market participants and economists have generally been in agreement with the directional trend. Is this time different? We are in a period of material lack of consensus among issuers/borrowers, the Fed, fed futures participants and economists. Following a ten year conviction that rates will rise, collectively the broader market cannot coalesce around a consensus regarding rates.
For example, the 10 year U.S. Treasury yield (UST) from November 8, 2018 to January 3, 2019 decreased from 3.238% to 2.554% while 1-Month LIBOR increased from 2.300% to 2.522%. This movement, coupled with the trickling of certain economic data have incited many market participants to reverse out of expectations of 2019 FOMC rate hikes The implied probability of Fed rate hikes back in November suggested at least two hikes in 2019. Fast forward 90 days, implied probability is mixed, with some expecting a rate hike and some expecting a rate cut.
The old adage is true, rates go up and rate go down. Understanding how it impacts your balance sheet, how you manage through the rate cycle, and how you prepare to take advantage of market opportunities, are important items to consider. Here are a few key takeaways and considerations as we live in the midst of these uncertain times.
For most borrowers, volatility creates a lot of angst and uncertainty. And while a knee-jerk reaction may be to eliminate volatility altogether, doing so can be cost prohibitive as cost is highly correlated with volatility (i.e. buying insurance after the house burns down).
It is reasonable to expect that volatility will continue to be inherent in our rate structure, particularly given artificial intelligence driven trading, algorithms, and regulatory dealer constraints around market-making and its impact on liquidity. Optionality, by definition, is a volatility based financial product and can be added to the composition of a debt portfolio. In most cases, borrowers have already purchased optionality in their fixed rate bond liability portfolio with callable bonds. A similar concept can be applied to a hedge portfolio as well. And while a currently outstanding hedge may not have any optionality, borrowers can add option-based products to their liability portfolio, that when taken in whole with existing hedge contracts, present characteristics very similar to a callable bond.
There are opportunistic times to buy or sell volatility, which tend to be contrarian to the general consensus of the market. When the market expects rates to rise as evidenced by the forward curve, buying optionality to cancel a fixed rate obligation trends lower on a relative basis and vice versa. What about today’s market? From a 15-year historical perspective, option volatility is lower than its average. Given the flatness of the curve and based on a borrower’s outlook on rates, one can buy or sell optionality at relatively attractive levels to reign in volatility.
Flexibility comes in many forms. As discussed in the previous paragraph, optionality can afford a borrower certain flexibility. Flexibility tends to come at some cost, although there are strategies to optimize and efficiently maintain flexibility.
One primary benefit of using hedging products is the ability to access the best source of capital and the ability to manage the rate risk. While bank financing has been the popular source of capital for the last decade, the capital markets are delivering some funding efficiencies not seen in the bank market. Maintaining documents that are multi-modal in nature allows a borrower to toggle back and forth between markets and rate modes, thus maintaining flexibility and agility within a liability portfolio. Likewise, borrowers can position their sensitivity to rate movements, irrespective of the funded capital, by using fixed rate payors or receivers to better optimize their fixed to floating rate composition.
#3 Holistic Laser Focus
While some borrowers may issue fixed rate debt and conclude that their organization is protected against any change in rates, that conclusion only addresses one simple aspect of the balance sheet. As most CFOs and treasurers know, the balance sheet of the enterprise is more dynamic, and the interrelationship between line item assets and liabilities can be complex.
While some balance sheet relationships may offset, some relationships may not be obvious. Take the example above with 100% fixed rate debt (traditional or synthetic). Assume in this example that an indirect debt lurks on the balance sheet in the form of an unfunded pension liability. What happens when rates fall? A downward spiral effect (or upward spiral of unfunded liability) occurs. Actual rate of return on the pension investments falls short of assumed rate of return. More importantly, the discount rate used in calculating the present value of the liability falls, putting upward pressure on the liability; collectively creating a double whammy. Using the LIBOR curve to discount with a 15 year term, a $50,000,000 unfunded liability would increase $1,600,000, adding just over 3% accretion to the mark. When taking a portfolio approach to both direct and indirect liabilities, some or more floating rate exposure (natural or synthetic) may be beneficial. Conversely, fixed income portfolios are susceptible to rates rising, with portfolio valuations falling.
Benefits of Holistic Analysis
The message is simple. Rate risk (whether up or down) is difficult to identify when looking at components of the balance sheet in silos. Taking a step back and looking holistically at the balance sheet in its entirety can help identity the true interest rate risk of the enterprise. Depending on the rate risk identified and sensitivity, risk tolerance, rate outlook, and intermediate and long term objectives of the organization, hedging products are available to recalibrate the balance sheet to meet the objectives of the institution to mitigate against a rise or fall in interest rates.
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