Interest rates in the U.S. have risen since December 2015, with particular upward momentum on short-term interest rates since March 2017. This has coincided with downward pressure on longer-term interest rates. Among market participants this situation is commonly referred to as “flattening” of the yield curve, or a lower spread between short and long-term rates.
Other things equal, interest rates tend to slope upward as time-to-maturity increases. This is due to investors’ demand to be compensated for the additional risk incurred through a longer timeline. An inverted yield curve implies these bond investors expect longer term interest rates to decline, typically due to the Federal Reserve decreasing rates due to a recession.
The U.S. Federal Reserve has hiked rates three times in 2018, including one at their most recent meeting in September. The market anticipates one more increase by yearend. However, there are members of the committee who are skeptical of these hikes in 2018, as shown in the quote below from the August Fed meeting.
“Participants also discussed the possible implications of a flattening in the term structure of interest rates. Several participants cited statistical evidence for the United States that inversions of the yield curve have often preceded recessions…and suggested that policy-makers should pay close attention to the slope of the yield curve in assessing the economic and policy outlook. Other participants emphasized that inferring economic causality from statistical correlations was not appropriate.”
Those skeptics may have a point; an inverted yield curve has long been a moderately accurate predictor of upcoming recessions. The Federal Reserve Bank of New York published an article in 1996 studying the correlation. ( full article here)
Whatever the market brings, hedging can improve consistency and reduce variability in interest expense. There are many products in the market to best fit each risk profile; the most common interest rate products are swaps and caps. Swaps entail exchanging the fixed or floating payments of interest expense faced on debt for the opposite, in order to reduce or increase exposure to fluctuations in rates. The fixed rate is set based on the forward curve and due to the current flat shape of the back end of the curve, the relative cost to swap longer tenors is much more favorable than in the previous years.
The figure above shows the historic and forward rates curve in 2017 vs. the same curve today. While the start of the curve is steeper today as a result of the expectation of multiple more Fed rate hikes in the near-term, the long-term rates do not continue the upward trend. This creates a more favorable hedging environment for those looking to hedge long-term floating rate debt payments, evident in the difference between a 4-year and a 5-year swap rate, which is calculated using the weighted average of the forward curve. Adding a fifth year in today’s market is essentially free, adding 0 basis points to the 4-year swap rate, and compares to 7 additional basis points for the same add-on one year ago.
A forward hedge is comparable structurally to a spot-starting hedge with the difference being that it will become effective in the future. It is a strategy most often used by our corporate clients to manage upcoming cash flows. For example, if a company anticipates floating interest rate payments starting in a year and lasting for five years, they could execute a forward starting fixed-for-floating swap today that would align their swap with their interest rate payments. Depending on the timeframe of the hedge, the “forward carry”, or difference between the forward swap rate and the current rate for the same tenor, can actually be negative in today’s environment. For instance, if I want to hedge a potential 5-year debt issuance in the future, I would find more favorable pricing with the effective date falling in 2020 compared to it being in 2019. It has been more than a decade since we’ve seen a curve with negative forward carry, and while the negative forward carry amount is pretty minimal now, keep your eye on this metric in the upcoming quarters. See the chart below for a visualization of this concept.
Chatham recently worked with a public United States energy company on hedging their future fixed rate debt. The client frequently issues bonds and with three bonds coming due in the next few years, they wanted to investigate hedging to lock-in current market rates for their refinancings in 2020. Entering into forward starting hedges now allows them to take advantage of the favorable forward curve without being subject to where rates may go. A cash settlement at the maturity in 2020 of the current bond would offset the monetary value of the move in rates, creating a scenario where we are effectively locking-in current rates. See below for a diagram of how this product works in different hedging environments. When we ran the analysis, forward carry to 2020 was only four basis points. A one standard deviation move in rates would affect the refinancing by more than $50 million both negatively and positively. Forward starting swaps would mitigate this risk. Along with forward starting swaps, there are several other hedging products available that offer flexibility to best fit our clients’ risk profiles.
Chatham Financial is an independent advisor that specializes in arming clients with the information and tools needed to achieve efficient execution of interest rate transactions. We structure and execute over $550 billion in derivatives transactions for our clients annually, facing over 120 different bank counterparties. We bring deep expertise across all of the components that add to the market price of a transaction, from credit charges to liquidity to bank profit. We use this expertise to enhance a corporate treasury team’s ability to achieve the most favorable balance of strategic risk management, efficient market pricing, bank relationship management, and operational feasibility.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit https://www.chathamfinancial.com/legal-notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 18-XXXX
About the Author
Garret Lee is an analyst on Chatham's Treasury Advisory group in Denver, specializing in foreign currency and interest rate hedging analytics and strategy. Garret joined Chatham in 2015 after graduating from the University of Denver. He graduated Summa Cum Laude with a BS in Finance and Mathematics.
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