Strategies to help manage interest-rate risk

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

With unprecedented economic and market uncertainty, business owners and investors are looking to stabilize their finances and mitigate risk. We asked Tony Liu, 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? 

TL: 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. At the same time, many companies also utilize hedging strategies to manage cashflow and interest expense. The flexibility of hedging products makes them a useful tool for our corporate clients.

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

TL: Higher benchmark rates, like SOFR and Treasury Rates, will increase debt financing costs for companies. Additionally, sharp increases or volatility in general can make financial and business management more challenging. 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? 

TL: There was certainly a period of time when interest rates were low and relatively stable. Since 2022, we've steadily moved past that environment and into a new rate landscape. But there are additional steps that need to be taken in today's environment since we have moved to a higher rate, more volatile environment.

Q: What are those steps? 

TL: One strategy for managing interest expense is 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?

TL: A company may be entirely financed through loans. Those credit facilities are generally 100% variable in nature. Therefore, upon the origination of those types of loan facilities, a company has exposure to short-term rates moving higher. Conversely, a company may be entirely financed through fixed rate bonds that all mature around the same time. Those companies are exposed to long-term interest rates and Treasury yields around when they need to refinance their debt. Therefore, even though those companies are 100% at most times, they are exposed to long-term rates moving higher and being high during the period of their refinancing. Maintaining a balanced and diversified debt structure can mitigate these risks and our products help achieve this result. 

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

TL: Each one of our clients is unique, so we tailor our solutions to their balance sheet and aims. Generally, hedging strategies are a balance between garnering protection and certainty from noncore risks, like interest rates, versus achieving cheaper financing terms and costs of capital. For more creditworthy clients, we believe it's more prudent for them to pursue strategies that provide greater protection. For our clients with greater balance-sheet flexibility, seeking more value from hedging strategies may be a better fit.

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

TL: With hedging, you are effectively mitigating volatility by locking in benchmark interest rates and reducing exposure to this metric. 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?

TL: Having a disciplined, targeted approach to hedging and in managing the financing mix for the balance sheet over time is prudent. You can't necessarily predict or navigate around what the debt markets will bring. However, 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 that are independent of market conditions, which may focus 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 requirements, credit capacity and regulatory requirements needed to execute their strategy.   

To learn more about our derivatives and hedging capabilities, click here.

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/.