The Fed’s Emergency Rate Cut: Impacts on Interest Rate Hedges

On March 3, 2020, the Federal Open Market Committee (FOMC) made an emergency 50bp interest rate cut in response to the Coronavirus’ impact on the U.S. economy.

Both Cash Flow and Fair Value interest rate hedgers will be affected by the change.

In this blog, Hedge Trackers addresses the impact of what just happened for interest rate hedgers. How will each group be affected by the rate drop? What should you tell management about your hedge positions? And how will your debt and derivatives react? We’ll answer these questions and more, so you and your team can remain prepared during these changing market conditions.

Cash Flow Hedges

Our clients that issue variable rate debt hedge it into fixed-rate debt typically by using a pay-fixed, receive-variable interest rate swap.

While it’s true that the swap (derivative) will decrease in value as rates fall, it is also true that companies should be indifferent to that fact. Why? The goal of the hedge was to fix the company’s interest expense not only at a level it could live with but also to provide predictability for business purposes. Most of our Cash Flow hedge clients don’t hedge 100% of their variable rate debt, which means that the overall economics of lower rates work in the company’s favor from an economic standpoint. The un-hedged portion of the debt portfolio produces lower and lower interest expense as rates fall. New credit facilities will also benefit from these lower rates.

It’s important to keep in mind that even though your cash flow hedges are probably in a loss position, they continue to act as insurance against rising rates in the future.

Fair Value Hedges

Unlike our Cash Flow hedge clients, our Fair Value hedge clients do typically attempt to hedge 100% of their interest rate risk. In a Fair Value hedge, the change in the value of the derivative offsets the change in the value of the underlying interest rate instrument (fixed-rate debt, bond portfolios, etc.). So overall, when rates fall, the respective changes in value continues to offset one another in income. There should be little to no economic change in the net hedge position. Fair value hedgers holding pay-variable, receive-fixed swaps should expect to see large gains on their swaps, which will help offset the large losses on their fixed-rate debt.

How to Talk to Management

Sometimes, management can be uncomfortable with derivatives that lose money, but there’s more going on than meets the eye.

When derivatives lose money, it often means the rest of the business is doing better. For example, as interest rate swaps incur losses, those with variable rate debt that is only partially hedged and those in the market for fixed-rate debt that is only partially hedged are looking for lowered interest costs overall. At the same time, the hedge is performing as it should – to fix the rate of interest the business was relying on to meet its corporate objectives.

When companies hedge their interest rate risk, it allows for better predictability and an ability to more accurately price products and services.

Conclusion

The FOMC reduced its target interest rate by 50bps in an emergency rate cut on March 3rd. The range of the Fed Funds rate is now 1-1.25%.

Cash Flow hedgers will be impacted more than Fair Value hedgers, because they typically cover a lower percentage of their risk through hedging. As interest rates fall, the un-hedged portion of their variable rate debt performs better while the hedged portion continues to provide needed predictability. It’s important for management to know that when derivatives begin to lose money, it means the market is improving for the company.

Have additional questions about how the changing market conditions impact your business? Let’s talk.