Risky business Featured

8:00pm EDT June 25, 2007

No company with variable rate debt can afford to ignore its exposure to interest rate fluctuations. An effective interest rate strategy enables a business to better manage its exposure to unpredictable market conditions over the term of a financing and more accurately budget future interest rate expense.

Smart Business asked Guy Kossuth, vice president and managing director of PNC Capital Markets LLC, to illustrate how companies can reduce their interest rate risk and develop an optimal interest rate hedging strategy.

Why do companies need an interest rate hedging strategy?

Most companies have a good understanding of their financing needs. But once they have the capital structure in place, whether it is a term loan or revolving credit facility or a combination of both, they need to think about how they manage their interest rate exposure over the life of the loan. Since senior debt is funded largely on a variable rate basis, the tendency is usually to focus on the current variable borrowing rate, not on how these rates are anticipated to move over time. This can expose a company’s balance sheet to undue risk, especially if debt market conditions become volatile. Moving from a floating to a fixed interest rate enables a business to take some of the variability out of the equation because interest expense then effectively becomes an anticipated fixed line item for budgeting purposes.

What solutions are available?

Interest rate protection strategies are extremely flexible and can be customized specifically for a company’s debt profile and tailored to its risk management objectives. The most common solutions include:

  • Fixed rate swaps: An interest rate swap is a contractual agreement in which two counterparties agree to exchange interest payments at different rates through a stated maturity date. Swaps offer extremely flexible terms and are highly customizable, allowing a borrower to effectively convert a floating rate to a fixed rate, or vice versa.

  • Interest rate cap: A cap is an agreement that limits a company’s floating interest rate exposure to a specified maximum level for a specified period of time. In essence, a cap is an insurance policy purchased by a business to protect itself against rising interest rates. Unlike a ‘collar’ there is no minimum rate specified.

  • Interest rate collar: A collar provides a company with a floating interest rate range between a ‘ceiling’ and a ‘floor’ level.

How can companies manage their interest rate risk?

Executives need to determine their tolerance for interest rate risk and how much exposure their business can sustain on the liability side of the balance sheet. They also need to take a long-range view. A business may be enjoying the benefits of extremely low floating rates and hope that rates will remain stable for the foreseeable future — but there are no guarantees.

It is also important to consider future plans, especially if they include an acquisition, a spin-off of existing operations, a restructuring or recapitalization. It may be advantageous to think about an interest rate strategy in the planning stage of the refinancing, especially if the current interest rate environment is potentially more attractive than is forecasted at the time the financing is targeted to close. Finally, executives need to revisit their interest rate hedging strategy periodically and make adjustments based on their company’s changing needs and market conditions.

How do you determine what risk strategy makes sense for your company?

Some companies are in a better position to tolerate risk than others. A paper manufacturer with low profit margins and high capital expenses may be extremely sensitive to interest rate increases, especially if it is unable to pass on its higher costs to its customers. In contrast, a specialized technology company with greater pricing power might be less sensitive to market fluctuations because it has greater flexibility to manage the revenue side of the equation over the term of the financing.

Ultimately, every company needs to be comfortable with its level of interest rate exposure. Markets are inherently volatile, so executives need to take a long-term view, recognizing that while they may not ‘lock in’ a fixed rate at the lowest point, a well-conceived strategy will help a company to better plan its interest rate expense management and may even save money.

To learn more, check out PNC’s Middle Market Advisory Series at www.pnc.com/go/derivatives.

This article was prepared for general information purposes only. Under no circumstances should any information contained herein be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. The information herein does not constitute legal, tax or accounting advice. Opinions expressed here are subject to change without notice. PNC Capital Markets LLC is a registered broker-dealer and a member of SIPC and NASD.

GUY KOSSUTH is vice president and managing director of PNC Capital Markets LLC. Reach him at (412) 768-7977.