With interest rates still at historic all-time lows, now may be an opportune time to lock in rates on variable long-term debt, especially given the backdrop of potential rate increases by the Federal Reserve.
“Right now the market is predicting that the Federal Reserve will increase short-term interest rates two or four times this year,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “The truth, however, is that no one knows what will happen, not even the Federal Reserve. Many variables can impact the magnitude and frequency.”
Traditionally, companies would mitigate interest rate risk by choosing a fixed rate loan. In today’s market, a company can employ a more customized strategy using interest rate swaps that can actively manage potentially rising interest rate costs.
Given the inherent uncertainty and volatility with the interest rates going forward, managing interest rate risk by using an interest swap or securing a traditional fixed rate are examples of commonly used risk mitigation tools. But companies should form their own risk management strategy that is developed based on their view of the market and their unique risk tolerance level.
“It should be a strategy that says, ‘This is our view of what may happen to interest rates and these are the risks we’re willing to take.’ And companies should adhere to it regardless of what rates do,” Altman says.
Smart Business spoke with Altman about strategies businesses can use to mitigate the risk of interest rate increases.
What should companies consider as they create a plan to mitigate the effects of an interest rate increase?
Risk mitigation strategy is based on a company’s risk tolerance, the amount of debt it holds and its perspective of the market. Interest rate predictions offered by market analysts shouldn’t be the only consideration because no one really knows what will happen next. The economy is global and issues outside the U.S. impact the domestic market. So companies must operate within their set risk strategy, which is based in part on what their business can handle if rates were to change.
With the company’s expected debt levels and associated finance terms in mind, determine what risks can be absorbed. The questions to ask are:
- What is the risk to the business if rates increase?
- What is the effect at each stage of an escalating increase?
- How high could interest rates rise before it becomes a problem?
- Is the company willing or able to risk that its costs will increase to that level?
Most borrowers do not delve this deep into the impact of interest rates, and it’s a simpler question: Do I prefer a level of certainty of interest cash flows or am I comfortable with the uncertainty of the future?
Once those questions are answered, then determine how to keep risk within manageable levels. Once a strategy is formed, execute on it.
How do businesses benefit from using interest rate swaps to hedge against interest rate increases?
It’s really about managing interest rate exposure. An interest rate swap is an alternative way to manage variable rate exposures and gives the borrower an opportunity to customize that exposure and risk tolerance to fit the borrower’s strategy. Whereas in a traditional fixed rate loan, the company would fix the rate on the entire loan amount, the interest rate swap allows a company to set how much floating rate exposure it wants, determine when the hedge will start, and how long it will be in place. For example, if a company is building a new facility and will take 12 months to do so, the company has the ability to set a fixed rate at closing to begin when the construction loan matures and the permanent loan begins 12 months from now, eliminating the interest rate risk between the start and end of the project.
There’s a benefit to having interest rate protection, whether that is through an interest rate swap or traditional fixed rate loan. It provides a level of certainty and allows businesses to focus on their day-to-day operations. Businesses need to think about their risks and have a strategy to protect themselves. Develop that strategy, implement it and stay true to it irrespective of what’s happening in the market.
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