Strategies to help manage interest-rate risk

Editor's note: This article has been updated from its original publication Aug. 17, 2023

With interest rates near their highest level in more than 15 years, business owners and investors are looking to stabilize their finances and mitigate risk. We asked Joel Essington, managing director and head of corporate rates derivatives origination for Capital One, for strategies and tactics they can adopt to cope with market volatility and financial uncertainty. 

Q: Why does managing interest-rate risk matter for businesses? 

JE: No one can predict the future, and companies should be in the business of running their business and not speculating or taking a view on how the debt markets and interest rates will perform. An effective risk strategy can smooth out some of the volatility and introduce the concept of greater predictability independent of what happens to interest costs.  

Q: How does interest-rate volatility impact financial performance? 

JE: It’s entirely capital-structure dependent. When you combine the dynamic nature of corporate balance sheets and introduce the concept of interest rate volatility and financial risks into that equation, it raises concerns about earnings stability, cash-flow generation, and so forth. Most businesses, especially publicly traded ones, want certainty and visibility. They want the ability to budget and plan and forecast accurately to their investors. So mitigating interest-rate risk should be front of mind, especially with markets like they are today.

Q: Given that low interest rates persisted for so long, is it harder for businesses to shift their interest-rate strategies today? 

JE: We've been spoiled for a long time in terms of a low volatility, low nominal-rate environment. And there certainly appears to be some thought that things will revert to “normal.” But there are additional steps that need to be taken in today's environment in case that is an incorrect view.  

Q: What are those steps? 

JE: One strategy for managing interest expense on a short-term basis can be traditional cash-flow hedging, in which variable rate risks are managed through a combination of pay-fixed interest-rate swaps or interest-rate options. For businesses that are more reliant on public bond markets, instruments such as forward-starting swaps and options on swaps, or “swaptions,” may eliminate volatility and potential price risk. 

Q: Can you give an example of how that works?

JE: A company may have 100% exposure to the Term Loan A, pro rata, or institutional loan market. Those credit facilities are 100% variable in nature. Therefore, on issuance of those types of debt facilities, a company has exposure to short-term rates going forward. Most balance sheets do not support adding concentrated risk on either end of the spectrum—100% floating or 100% fixed. So implementing a paid fixed interest rate swap can provide a more neutral balance. If you can do 50% fixed and 50% floating, or something in that range, it’s a more prudent strategy. 

Q: How should a company evaluate an effective hedging strategy? 

JE: Each scenario is different. It depends on the cyclicality of a business and capacity on the balance sheet for absorbing interest-rate risk. Once a company identifies the interest rate factors affecting their business, the next step is to determine the appropriate strategy to mitigate rate volatility over time. But it’s important to remember that these strategies should be developed independent of market conditions. That can be difficult to remember in the current environment, but managing rate risk and financial risk should not be a reactionary response to market conditions. 

Q: How can this help create cash-flow certainty? 

JE: With hedging, you are effectively mitigating volatility by locking in either an interest rate or a nominal amount of a hedge through a specific duration of that underlying transaction. That essentially creates certainty around free cash-flow generation. So hedging is a prudent strategy for reducing financial market risk, and it can be an important component of a broader risk management strategy. 

Q: Why should companies optimize their risk management strategy?

JE: Having a disciplined, targeted approach to hedging and in managing the specific funding mix for the balance sheet over time is essential. You can't necessarily predict or navigate around what the debt markets will bring. But you can provide some certainty in terms of preservation of economic value, specifically around interest rate, risk, and volatility.  Prudent risk managers should focus on developing an internal framework and risk management policy, independent of market conditions, which focuses on: 

1. Quantifying exposures and understanding their risk tolerance

2. Defining risk management objectives and evaluating alternatives

3. Formally documenting their hedge policy and obtaining internal approvals that are required to move forward with their strategic objectives

4. Working with relationship banks to address pre-trade documentation, credit-limit capacity and regulatory requirements that are needed to implement their strategy.      

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Disclaimers & disclosures

This material has been prepared by the Sales and Trading Personnel at Capital One, N.A., its affiliates or subsidiaries (“Capital One”) with responsibilities for marketing and sale of swaps and other derivatives.  All questions related to swaps referenced in this article must be directed to derivatives_marketing_ird@capitalone.com.  This material is not intended as objective analysis and advice, nor should it be construed as tax, legal, financial, accounting or other advice. This material is not a research report and it reflects the views of the author which may differ from the views or opinions of others at Capital One, including any Capital One research analyst or research team. Where distribution of this material is subject to the rules of the U.S. Commodity Futures Trading Commission (“CFTC”), it is a “solicitation” of derivatives business generally only as that term is used within CFTC Regulation 23.605. No investment decision should be made in reliance on this material, which is condensed and incomplete; does not include all risk factors or other material matters; does not take into account the customer’s financial conditions, risk management or hedging needs; and is not intended as advice regarding or recommendations of particular risk management strategies, trading strategies or investment advice or a basis to consider Capital One to be a fiduciary or municipal or other type of advisor.  For important disclosures, including risk disclosures, conflicts of interest and other terms, conditions and disclosures related to CFTC-regulated swap transactions, please see our website: https://www.capitalone.com/commercial/capital-markets/interest-rate-derivatives/swap-dealer/.