Good things are happening in British business
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Read time: 7 mins Added: 29/10/21
When the first UK lockdown was announced in March 2020, few of us would have anticipated that we would still be living and working under such uncertainty well over a year later.
For many treasury teams, those initial months could probably best be described as firefighting. As well as operational challenges – such as supporting colleagues through the shift to remote working – businesses have had to deal with the immediate impact of lockdown on operational performance.
Cash flows fell sharply as lockdown took effect, so securing liquidity and shoring up balance sheets was the initial priority for many.
The ongoing uncertainty and resulting market volatility have prompted many companies to review their strategies across transaction and balance sheet hedging, as well as interest rate risk management. This has involved revisiting the rationale for their hedging policies and looking back at the issues faced during the crisis to understand what lessons can be learned.
With senior management increasingly focused on what their treasury team do and the value they bring, treasuries are being given the platform to brief a wider range of stakeholders within their company on the value of financial risk management. This includes what the current strategies are designed to achieve, whether they are still fit for purpose, and what can be done differently going forward.
In 2021, senior management and boards are more open to new ideas, giving treasurers the chance revisit their strategic planning and refresh old policies.
It’s an opportunity that should not be ignored. The question is, what should treasurers be prioritising when reviewing their treasury policies?
Transaction hedging has been one of the most challenging areas for treasurers to grapple with throughout the pandemic. Typically, companies hedge forecast cash flows for foreign exchange (FX) or commodity risks in a systematic manner – for example, via layered or rolling strategies using forward contracts out to 18 to 24 months. But these strategies are built on having stable and predictable forecasts.
During the initial months of the crisis, operating cash flows declined dramatically in numerous sectors and we saw large market movements and high volatility. This left many companies over-hedged, needing to unwind, restructure or roll forward trades, adding to liquidity pressures.
In many sectors, uncertainty in cash flow forecasts remains one of the key difficulties, and having the confidence to re-engage in the market and restart hedging programmes has been challenging at best. This is forcing treasurers to look again at their hedging strategies and whether they are fit for a riskier economic environment.
To respond to the ongoing uncertainty, many treasurers have worked to develop their forecasting approach to build in and stress test a range of scenarios for both cash flows and market rates rather than relying on a single ‘central’ forecast. This enables them to assess the impact of uncertainty on their key financial metrics, review whether their risk appetite may have changed, and analyse the pros and cons of their existing hedging strategy.
In the sectors most negatively affected by the pandemic, businesses have been working to build greater flexibility into their hedging strategies. Examples include hedging for shorter periods – perhaps for 12 to 15 months instead of 18 – and providing the ability to flex hedge ratios within a range – such as covering 50% of forecasts instead of 75%.
Many companies have also considered the use of option-based strategies to reduce the risk of over-hedging, maximise credit line availability and avoid the hedge portfolio moving significantly against them.
A number of treasury teams have also looked to develop their execution strategies, such as leaving limit orders for trades that will be executed should the market reach a certain level in order to avoid missing favourable movements.
Whichever approach fits best, treasurers should look to take the initiative, monitoring markets and making decisions according to the circumstances rather than following a 'mechanical' policy. They should be proactive in communicating their strategy to senior management and stakeholders, so that they understand exactly what hedging is designed to achieve.
It’s important for everyone to understand, of course, that while transaction hedging can defer or smooth market movements, it cannot avoid them forever.
Before the pandemic, many companies had grown accustomed to low, flat interest rate curves and low volatility. Because of this, they had perhaps taken a more tactical than strategic approach to their interest rate hedging.
While market volatility is currently relatively low, there is still a great deal of uncertainty around the potential future path of interest rates, not least due to the monetary and fiscal response to the crisis, the pick-up in inflation during 2021 and the ongoing debate over how central banks will respond.
Cash balances have also increased significantly through the pandemic and now need to be factored in, given the low returns they earn and the impact this has on the cost of carry – the difference between the cost of debt and return on cash.
Treasurers should review their interest rate risk management policies and consider whether they need to find a new balance between strategic and tactical factors.
This could include revisiting the connection between operating cash flows and the interest rate and inflation environment, or the impact of increased liquidity buffers and cash balances on the company’s fixed or floating mix.
The steepening of interest rate curves in the first half of 2021 provided an opportunity for many companies to rebalance their debt portfolios away from fixed rates and towards floating rates. This reduced their overall cost of carry while offsetting the risk of low near-term rates on their increased cash balances.
Many companies are continuing to monitor market levels, hoping to increase the proportion of floating rate debt in their businesses to address these issues.
Others who continue to see longer term rates as historically low may take the opportunity to lock in for the foreseeable future, both by issuing longer-dated debt and pre-hedging future debt maturities.
Like interest rate risk management, before the pandemic many companies had become used to low FX and interest rate volatility and stable market conditions. In that environment, they focussed more on reducing the overall cost of funds by having a greater percentage of debt in currencies with historically lower interest rates, like the euro, rather than aligning the currency mix of their debt portfolio with EBITDA or operating cash flows.
This approach may have worked well when market conditions were stable, and the companies had sufficient headroom in their key financial metrics to accept greater risk in return for cheaper funds. However, we’ve seen the pandemic’s impact on credit metrics and the relative ‘compression’ of interest rates between different currencies.
Treasurers should review their company’s currency mix of debt to understand the balance between risk and reward, and determine if it is still appropriate for them. This might mean using current market rates to rebalance towards a strategy designed more to mitigate risk than to achieve cost savings. The key to any strategic review is to fully understand the trade-off between risk and reward, and to articulate this to senior stakeholders to get their buy-in.
There has rarely been a more opportune moment to review treasury strategies. Against a more benign but still challenging backdrop compared to the past 18 months, the treasury teams that prosper will be those that balance managing risk with ensuring their business has the tools to capitalise on growth opportunities.
The Financial Risk Advisory team at Lloyds Bank can help with analysis and guidance for treasurers approaching a review of this kind. The timing might never be better for initiating strategic change.
Colin McKee is head of the Financial Risk Advisory team at Lloyds Bank Corporate Markets.
All lending is subject to status. This article is produced for general information only and should not be relied on as offering advice for any specific set of circumstances.