A switch in time

Nobody foresaw that the collapse of the US sub-prime mortgage market would
lead to the first run on a bank in the UK for more than 100 years. The crisis
saw short-term interest rates spike as the interbank market became moribund and
Northern Rock hovered on the brink of collapse.

Sky-rocketing interest rates came as a shock to the financial markets. For
the past decade, an independent Bank of England has presided over a stable,
low-interest rate environment with sudden rises in the cost of borrowing seen as
a thing of the past.

The sharp rise in interest rates has made finance directors sit up and think
about the best way of managing their interest rate risk. Inés de Dinechin,
global head of interest rate derivatives risk management at Société Générale,
says, “Since the credit crunch, we have seen some companies which we’ve talked
to in the past come back to discuss hedging their interest rate exposure.”

Swap shop
Mortgage lenders and banks are familiar with the use of interest rate swaps as
hedging instruments, but using derivatives instruments as a form of insurance
against interest rate risk can be used by any company of any size in any sector.

“When it comes to advising companies on whether they should hedge their
interest rate risk, I ask them this question: ‘If interest rates were to rise
suddenly, would it have a material impact on your business?’ If they say ‘yes’,
then they should hedge,” says Nick Soper at Investec Investment Bank.

Most companies will have some form of debt financing. If they are borrowing
from a bank, they will be paying floating interest rates. If higher rates could
have a serious impact on the company’s profitability then entering into an
interest rate swap to a fixed rate enables the company to lock in a guaranteed
level of payment.

Similarly, a company that issues a fixed rate bond could swap this into
floating rate if it suited the company to have part of its liabilities payable
at a fixed rate and part at a floating rate. “A company should ask itself
whether it prefers the certainty of the fixed rate or if it would prefer to have
a proportion of its interest rates at a floating rate,” says Colin Martin at
KPMG. “It’s often cheaper for a company to issue its debt at a fixed rate and
then swap that debt into floating.”

The past few years have seen a frenzy of M&A activity, with private
equity particularly active, often using highly leveraged financing. “Many of
those firms would hedge their interest rate risk to protect their dividend
income,” says de Dinechin. If the current crisis leads to a sustained slowdown
in private equity’s acquisition activities, companies may not have to hedge as
much as they have done in the past.

Accounting for derivatives
The spike in short-term interest rates has made companies think about putting a
pre-hedging interest rate swap in place to protect planned debt financing.
However, entering into a derivatives agreement has accountancy implications.

Accounting standard IAS39 covers the treatment of derivatives used in hedges.
It says that any derivative, except a written option, can be used as a hedge. It
is much more difficult to show how a complex instrument is an effective hedge,
so companies tend to use simple instruments.

The standard permits a ‘cash flow hedge’, but the cash flows being hedged
have to be highly probable. This is where using a pre-hedge can become a
problem. For example, pub group Mitchells and Butler had been planning a £4.5bn
property joint venture with Robert Tchenguiz’s R20 investment vehicle, but this
was put on hold because of the market turmoil.

Before the deal went ahead, the group took out interest rate and inflation
hedges as insurance. As the deal never happened, these debt cash flows were no
longer highly probable so the swaps do not qualify under IAS39 for hedge
accounting. This means that the instruments have to be marked to market and
changes in fair value of the hedges have to be recorded in its P&L.

The turmoil in the markets has seen the value of the hedges reduce sharply
and the company has seen its deficits balloon. In effect, the company has
inadvertently seen its losses just keep growing.
Experts agree that interest rate swaps can be extremely helpful in managing
interest rate exposure, but finance directors will have to think long and hard
about a broad range of possible outcomes before going ahead.