Can you already hedge interest rate risk if you have not yet taken out financing?

Depending on the situation of their company, our clients monitor the financial markets more or less closely, but in the current volatile market, interest rates are followed by many on a daily basis. For customers who are about to take out new financing, the base interest rates (Euribor and the interest rate swap) and the development of the credit margins are particularly important.

Regular refinancing

In the case of a regular refinancing, we often see that customers (and banks) can “time” this to a certain extent. You don't have to wait until year 5 to refinance your 5-year facility. If the market is favorable, i.e. the credit margins are relatively low, you can also refinance in year 3 or 4. In that case, the benefit from a lower credit margin going forward makes up for the extra upfront costs. Since the lead time of a refinancing is relatively short, the risk of a rising base interest rate does not remain open for too long.

However, we are now in a macro environment where a period of 2 to 3 months can already mean a lot for the Euribor and swap rate. For example, look at the year-to-date chart below of the 3-month Euribor and the 5-year swap rate.

Interest rate risk in an acquisition or large investment

In other words, within the framework of a regularly planned refinancing, interest rate developments are already important because of the possible financial impact on the company. But what about the situation where a company is engaged in a transformative transaction, such as a major investment or acquisition? A number of factors play a role here, which makes managing the interest rate risk extra difficult and at the same time extra important.

Often long period of uncertainty

In a transforming transaction, the hedging issue is extra difficult because of the uncertainty about whether the transaction will go ahead at all. With an M&A transaction this is immediately clear, the deal is only done when the fat lady sings. But even with a large investment, we often see that it is preceded by a period of uncertainty that can last a very long time. Does the company obtain the necessary permits? Is a possible subsidy process properly completed? Does the project still manage to cope with the rising price of the contractor? And finally, does the company get the final “go” from its stakeholders?

Great importance to mitigate risk

At the same time, the importance of risk mitigation is extra relevant. Firstly, an acquisition or major investment is often accompanied by a relatively large amount of additional financing, which is also taken out for a longer period of time. This means that the additional interest rate risk, which is thus brought in, will often become significant for the company in an absolute sense (measured in EUR) in the coming years.

Secondly, we see that the leverage increases as a result of this extra financing. Since it is sensible to build in more safeguards, with regard to risks outside the operational sphere, when leverage is higher, this additional financing also leads to a greater need to hedge the interest rate risk. In this situation, we often see that banks want a (significant) part of the interest rate exposure to be hedged.

In summary, taking out a hedge in a transforming transaction is important because the interest rate risk often involves a lot of money and because managing this risk - with higher leverage - is extra important. However, we also indicated above that at the same time we also need to find a way to deal with the uncertainty that there is about the transaction going through.

Hedging in uncertainty

In addition to these “internal” concerns, there is also an important “external” element associated with the aforementioned uncertainties. As long as the transaction and the associated financing are not 100% certain, it often proves very difficult to conclude an interest rate hedge transaction with the bank.

This applies primarily to interest rate swaps, in which an obligation/exposure may arise from the customer to the bank as a result of the market value development. With a financing that is uncertain, this is a risk that you as an entrepreneur definitely want to avoid. The same applies to the bank. They also want to avoid having a credit risk arising from an interest rate swap associated with financing that never went through. In our previous article, we already established in this context that banks no longer want to have “loose swaps” in their books. A trend that is not only due to the sympathetic concern of your banker, but also from the duty of care on which the bank is monitored and which obliges the bank to ensure that you only cover risks and do not create new risks with derivatives.

The foregoing means that the hedging solution must generally be found in the sphere of options, such as the purchase of interest rate caps or a swaption.

Interest rate cap: purchasing an interest rate cap protects the company against an increase in the Euribor interest component of its financing costs during the term of the financing. Above an agreed "strike", the increase in the euribor is reimbursed 1-on-1 by the bank. The company pays an upfront premium for this. A lower strike or a longer duration leads to a more expensive interest rate cap. Swaption: purchasing a payer swaption (swap option) protects the company against the rise in the swap rate if it intends to enter into a payer swap at a known future time. The swaption is an option to enter into a swap at a pre-agreed swap rate, which is the strike of the swaption. This option is usually cash settled if it is “in the money” at the end of the term. The amount that the company will receive in that case is equal to the extra costs it will incur in the future as a result of the increase in the swap rate in the market above the agreed strike. The following also applies here: the premium is paid upfront and a lower strike or a longer term of the option leads to a higher premium.

When using options, the bank's duty of care also requires that you be able to demonstrate that the desired options match the modalities of your financing (size, term, base rate, etc.). However, since the purchase of an option (whether it concerns an interest rate cap or a swaption) can by definition never create an obligation from the customer to the bank, the compliance bar is set a little lower here and these can often be closed if the transaction and financing are not yet 100% certain. Under certain conditions, it is even possible to include the purchase costs of options (the “premium”) and the result upon exercise thereof in the interest costs over the term of the financing by means of hedge accounting.

Given the interest rate rise in recent months and the acceleration of this rise since the war in Ukraine, interest rate hedging is also a hot topic for clients who face uncertain exposures due to ongoing M&A transactions or large investment projects. In recent weeks, we have therefore assisted several clients in their analysis and the negotiation/execution of transactions to cover their interest rate risk by means of options.

We would be happy to discuss the interest rate risk of your company and the options with you that are in place to manage this risk.