Good things are happening in British business
Find out how some of our customers have evolved their businesses in innovative ways.
Read time : 5 min Added: 01/12/2022
Soaring energy prices driven by geopolitical risks, multi-decade highs in inflation leading to rapidly rising interest rates, the return of exchange rate volatility and the looming threat of recession are all part of this shift.
In particular, the seismic shift in the interest rate and credit markets and withdrawal of the unprecedented liquidity support that has characterised much of the past decade have caused borrowing costs to rise rapidly across the globe.
For companies with significant debt financing needs or with operations or assets that are vulnerable to changing rates, these movements represent a profound shift. Treasurers and finance teams may need to reassess borrowing and liquidity requirements and reconsider hurdle rates for new business as they compete for capital. They should also consider how both could inform the composition of their debt portfolios.
The speed with which interest rate curves have steepened has surprised many in the market. For many people working in treasury this could be their first experience of a higher, more volatile interest rate environment, and in particular, steep curves at the front end. Even for longer-serving treasury professionals, the absence of a need to take a strategic – rather than tactical – approach to interest rate risk management may have weakened their ‘muscle memory’ when it comes to dealing with higher rates and the current level of uncertainty.
The benign interest rate environment over the past decade or more has meant that interest rate risk management was both relatively straightforward and a low-stakes decision. Many companies simply maximised the proportion of fixed-rate debt in their capital structure, as there was little perceived benefit in borrowing on a floating basis relative to the additional risk. For many companies, the decision was simply whether to opt for long or short maturities depending on their needs.
Now, volatile markets and the level of uncertainty over the path of central bank rate hikes make the decision between fixed and floating rates much more challenging as there are risks either way.
Two of the immediate concerns in a rising rates environment are the ability to raise debt financing when needed and the return that investors or lenders may require. In such an environment, preparation is critical. It is important that companies understand their liquidity and financing needs (and financing cost expectations), and are positioned to take advantage of opportunities as they emerge.
Companies are now moving away from the more tactical approach of recent years and are starting to rebalance their debt portfolios more strategically. For example, we have recently seen companies adding floating-rate debt to their portfolios as they raise new financing in order to balance their risk position more evenly and to align their interest rate mix to strategic factors such as earnings cyclicality.
Similarly, with the historic movements in exchange rates and the difference between the projected path of interest rates in major currencies, many companies have considered whether to rebalance their debt currency mix more strategically, for example, to lock in the strong dollar for their US operations.
Treasury teams faced with a more challenging interest rate and borrowing environment need to get back to basics. Dust off the debt management road maps and reassess the organisation’s earnings profile, risk framework, existing debt composition and future borrowing needs.
Understand the current market dynamics and risks. Consider the development of the rates cycle and the possibility that central banks could be forced to cut rates rather than raise them if inflation falls more quickly than anticipated. In the same vein, understand how central bank policies and other factors are likely to drive exchange-rate movements. Also consider the scenario where inflation is more persistent.
It is imperative that companies understand the impact of the repricing of market risks on their business and are able to communicate this with stakeholders. While each risk class can be analysed separately, it is important that companies are able to form a holistic view of the overall impact of market risks on their business – for example, on operating margins, KPIs and credit metrics.
Companies should review the strategic factors that typically drive the fixed/floating and currency mix of debt, including the earnings profile, degree of leverage, cyclicality, cash balance and forecasting certainty. The strategic risk management approach should be refreshed and balanced with tactical factors to allow the company to react to market developments.
Some borrowers may be willing to pay a premium in order to achieve certainty of financing and de-risk near-term debt maturities. While pre-funding has clear benefits, carrying more cash could act as a drag on performance given higher credit spreads. Pre-hedging should also be on the radar for those seeking to reduce interest rate risk. Companies can layer into hedges over a period of time in order to spread their execution risk.