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Monday, 2nd December 2024 |
Bespoke interest rate risk management is best option |
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The key to good funding and interest rate risk management strategies is to align the debt and interest rate profile with the objectives of the business writes Declan Fitzgerald. |
A UK survey last year by the Association of Corporate Treasurers (ACT) and Ernst & Young found that 100 per cent of respondents had a treasury policy in place. While this implies that they all have funding and interest rate policies, the question remains whether those policies are robust and match their business needs.
Up to Q3 2005, treasurers operating in the euro zone could be forgiven for not looking too closely at their funding and interest rate policy, we were in a period of low interest rates and relatively low interest rate volatility. Since then however, the ECB have taken a very tough line on inflation and have increased rates by 0.75 per cent with at least another 0.25 per cent expected over the course of the next quarter. The question now is not where rates are going next but rather how high will they go and how quickly will they get there. This change in the interest rate environment will show any weaknesses in treasury policy.
Every business is different and every company's ideal debt and interest rate profile will vary. While the first thought may be 'How long can I lock out my financing for?' or 'How low can I get my funding cost?' there should be many other considerations in formulating funding and interest rate policy. Funding using short term facilities may reduce the cost of credit but is this appropriate where the asset being funded is a long term commitment?
Funding policy
Three key issues when designing a funding policy are:
• Type of instruments that provide the funding
• Maturity profile of the funding portfolio
• Currency mix of the funding portfolio
All three should be considered together against the background of the overall strategic direction of the business.
When deciding the type of instruments to use to fund the business, identifying the appropriate funding instrument is key while diversification of funding sources is also important. Possible sources include letters of credit (committed and uncommitted), leasing structures, bank loans, private placements, public bonds and equity.
While all companies may not have access to all markets, diversification of sources is important to ensure flexibility, best terms and conditions and funding certainty. Treasurers may also want to keep adequate amount of bank lines open in case future funding is needed quickly, for example to expand.
Each type of instrument typically has benefits and drawbacks compared with other types. For example, a private placement market might currently provide cheaper funding than bank debt but it is less flexible than bank debt. As such, treasurers should consider the mix of instruments carefully to ensure the correct blend of (including bit not restricted to) cost, certainty, flexibility and covenant restrictions.
Treasurers should also consider the maturity profile of their funding instruments. Examples of different approaches are; matching the maturity of the finance to the assets which are being funded; locking in financing for as long as possible to manage refinancing risk; and tenor decisions based on current levels of volatility of interest rates and credit spreads.
Matching the term of the financing to the term of the asset might be the chosen approach for funding a project or purchasing long term assets.
When it comes to deciding the tenor of funding, treasurers may wish to lock in the certainty of historically low lending margins for term funding or alternatively they may be comfortable that credit spreads will remain relatively stable and may fund for a shorter term to take advantage of lower short term margins, the risk being that credit spreads could subsequently move higher.
Businesses with international operations also need to consider the currency mix of the debt portfolio. It is generally considered prudent to match the currency profile of the debt to the currency profile of the business to minimise the impact of currency movements to the consolidated balance sheet. It�s possible to alter the currency profile through the use of derivative instruments.
Interest rate risk management policy
Interest rate risk is mainly managed through the choice of the fixed / floating mix of funding, for example, paying 50 per cent fixed and 50 per cent floating. The precise mix is generally dictated by the business�s risk profile and its management and/or shareholders� attitude to risk.
The fixed/floating interest rate profile can be adjusted via a number of flexible funding structures, for example, opting to have a fixed rate on a term loan or by way of derivative instruments. Interest rate swaps can effectively convert fixed rate funding into floating and floating into fixed. Caps, floors and more complicated options can be used to manage the interest rate risk of floating debt or to potentially alter the fixed funding cost.
High growth (high risk) businesses in cyclical industries may be better suited to floating rate funding while those in more stable, non-cyclical industries might be better suited to a higher proportion of fixed. Also the leverage and risk tolerance of the business will help set the percentage of the fixed / floating mix of the portfolio. Finally, treasurers with a desire to express their view on interest rates can tactically manage the ratio of fixed to floating rate funding to their expectations of rising or falling rates.
Treasurers may choose to increase the fixed proportion of their portfolio to assist in budgeting decisions, as the cost of financing for a project will be known with certainty. This way management can focus their energy to run the business / project to generate an acceptable return above the known cost.
Then there is the traditional mixed approach, where treasurers keep a certain level of their funding fixed, typically between 40-60 per cent. This approach is never more than 40 per cent wrong but equally never more than 60 per cent right!
Example
Let�s take an example of an hotelier, who just completed a large extension adding a state of the art leisure centre and health spa. Relative to his overall business, this is a major commitment. What factors drive their decision on funding and interest rate risk policy?
Building hotels is a capital intensive business. A significant time lag exists between the time the cash outflows at the start of the development process and income from the operation of the complex begins to flow. Certain factors can also exacerbate the time line. For example the planning permission process can be a drawn out process and construction can take longer than anticipated.
The size of the spend in relation to the size of the developer / operator and whether it�s a once off project or part of a larger program will have bearing on the decision to fund it separately or as part of it�s larger core funding. For our hotelier, this was funded as a once off project using conventional term bank debt. For treasurers operating in the hotel sector, there are many attractions in removing the uncertainty of interest rate volatility to allow them to concentrate on running their business.
Not fixing interest costs leave them exposed to the dual negatives of rising interest costs (and consequently an increasing debt burden) against a background of potentially lower consumer spending (as more discretionary spending is tied up servicing consumer debt).
Our hotelier made the decision to hedge the majority of the debt. The hedge he transacted provided certainty with regard to the overall interest cost while allowing for possible delays in the completion of the project. It also allowed for lower revenues and higher costs during the start up phase of the new complex. Incorporated into this solution was a flexible hedge start date and lower initial interest costs. This solution was specifically engineered to match their unique requirements to help them manage the uncertainties they faced in their particular business environment.
Having a financial service provider that understands your requirements and uses this knowledge to assist in constructing a sound risk mitigation strategy can be of great assistance, particularly with the variety of different and often complicated instruments now available. As markets have developed so has the ability to provide solutions to cater for specific customer needs over almost any time period. Our message to anyone involved in planning or implementing financial strategy is to regularly review your existing debt and hedging profiles versus your underlying requirements and keep them in line. With euro interest rates moving higher from historically low levels, any increase has a proportionally larger effect on the total costs of doing business. |
Declan Fitzgerald is head of capital markets at Ulster Bank.
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Article appeared in the August 2006 issue.
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