Following rampant inflation, the cost of borrowing in Europe has increased significantly, by up to 300 basis points for European Investment Grade (IG) corporates this year, largely mimicking moves in the US.
This can be particularly detrimental to corporates depending on the amount of floating debt in their portfolio. Those with significant floating rate loans may have increasing interest expense and concerns about covenants, in particular, if profitability is low. Finally, corporations considering a refinancing of existing debt may encounter a rather hostile market.
In this article we will briefly investigate the factors leading to the increase of interest rates and steps corporate treasuries could be taking to effectively manage their interest rate risk (IRR) in a volatile interest rate environment.
Following many years of low interest rates in Europe, the tide has shifted dramatically in 2022. The increase in the cost of raising new funds and servicing debts is reflected largely through four indicators; ECB lending rates, Interest Rate Swaps (IRSs), reference rates and Credit Default Swap (CDS) spreads. The rising rates of inflation forced the ECB to raise lending rates for the first time in eleven years in July 2022. This increase was followed by a further rate hike in September, together the increases resulted in a fixed lending rate of 1.25%.
The higher cost of borrowing and expectations of further increases has significantly reduced the availability of liquidity in the debt markets. Both IRSs and the Euribor rates are impacted by changes in the ECB lending rate and reflect expectations of changes in the cost of borrowing in the future. Increasing Euribor rates may make servicing existing debt more expensive with corporates paying coupons determined by reference interest rates experiencing significant increases in periodic payments, 3-month Euribor has already risen by 1.5% this year.
For IG corporates, the benchmark cost of borrowing new funds for five years can be established by combining the 5-year IG CDS spread (a measure of the credit spread corporates pay) with the 5-year IG IRS rate. Both the CDS spread, and the IRS rate have increased significantly since the start of the year.
Graph 1: The increasing benchmark cost of borrowing in the eurozone for IG corporates
and the movement in 3-month Euribor over the last 18 months.
Given the years of benign interest conditions and little appetite for hedging interest rate risk, corporate treasurers may have been caught off guard by recent developments. Should this be the case, we recommend that treasurers begin by establishing a more holistic financial risk management policy. The risk management policy should highlight to which different elements of interest rate risks the corporation is exposed to and from where on the balance sheet and P&L the risks originate. The policy should then also include relevant KPIs and the impact of changing interest conditions on KPIs, this can be modeled using scenario analysis. Finally, the policy should highlight available instruments for hedging excess risks that fall within the risk appetite.
When starting a risk policy, it is good to identify that there are two types of interest rate risk: fair value risk and cash flow risk. Fair value risk considers the volatility of interest rates on the price of assets and liabilities. This risk is relevant if loans are not held till maturity and should be included if there are expectations to sell off investments or to buy back loans prior to maturity. Cash flow risk is a direct risk to the P&L often resulting from increased interest payments. The cash flow risk usually represents the IRR of corporate borrowers and is the main focus of this article.
Next, it is prudent to consider cash flow risk for the corporation. Comprising a list of items on the balance sheet and P&L affected by interest rates changes is a starting point. Items on the balance sheet and P&L often impacted by interest rates changes are highlighted green in the figure below. These items can then be split into currencies and time horizons to give a more defined view of what exposure to rate changes the company is subjected to and whether there are natural hedges between incoming and outgoing funds already occurring.
Table 1: Sources of interest rate risk.
After identifying where the balance sheet is susceptible to changing interest rates, corporates should establish a number of KPIs and detail these in the risk policy with strong reasoning for choosing specific indicators. Some KPIs to consider are the fixed/floating ratio of debt, net exposure in one or multiple periods, duration of exposure, cash flow at risk and interest coverage ratios. These KPIs may have a desired range and hard limits depending on risk appetite. The risk appetite can be established by following a quantitative approach followed by discussions at senior management level and may be impacted by various factors. Such factors (e.g., Covenants, Leverage and the effect on the business model and margins) tend to make corporates more or less willing to embrace interest rate risk and may be reflected in acceptable ranges of KPIs.
Once KPI’s are defined, scenario analysis can estimate the effects of changes in various interest and reference rates on interest expense and KPI’s. We recommend that scenario analysis should be kept relatively simple with the effect on interest expense, financial ratios, and covenants from changes in interest rates often being easiest to digest when presenting analysis to colleagues and board members.
Having established the effect of rate changes on KPIs, treasurers can consider relevant financial instruments to alter exposure to IRR. These instruments could include one-off forward rate agreements to reduce excess exposure in certain periods, refinancing, floating to fixed IRSs, options (caps, floors, collars) etc. Once the instruments are established, it may be needed to take practical steps to allow future hedging if it has not been done in recent years.
Other non-instrument hedging solutions may also be available to corporates. Natural hedges can be considered that are created by altering investment strategies. Also, implementing working capital solutions and increasing the accuracy of cash flow forecasting can reduce reliance on expensive short-term funding solutions and exposure to raising interest rates.
A structured approach in creating a risk policy that identifies and measures risks before investigating instruments and solutions in line with corporate policy allows treasures to quickly implement risk-reducing solutions as the economic environment changes. The ability to act quickly on a defined plan can reduce uncertainty in the volatile interest environment corporates are experiencing since the start of the year.
For a quarterly update on changing interest condition in Europe we publish Zanders debt reports. Should you wish to be added to the mailing list of the debt report or if you would like to discuss any topics mentioned in this article, please feel free to contact Dan Sellers via +31 88 991 02 00.
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