Conducting a review of a company’s debt obligations and interest rate exposures can help any commercial borrower better understand their risks. A company can then establish an interest rate risk management strategy to guide it through the evaluation and define any financing related or hedging actions that are needed.

Whether it be the actions of the Federal Reserve or the LIBOR to SOFR transition, there are a number of significant developments in the market today that can impact floating rate borrowers in the future. This raises the question of when was the last time you took stock of all the company’s various exposures to interest rates?

Regularly reviewing your debt structure is a crucial step for understanding the potential risks and avoiding unexpected issues. Every loan should be assessed on its own terms, but a structured approach to risk management streamlines the evaluation process.

As a borrower, have you utilized interest rate hedging tools in the past? If so, are those hedges you put in place still aligned with your current goals and the market environment or should those hedges be restructured?  Finally, does the company have a defined strategy for managing floating interest rate risk that can help drive consistent and objective decisioning?

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5 step framework for evaluating a commercial borrower’s interest rate exposure

Developing an approach to risk management can be a valuable exercise for any company with floating interest rate exposure, without needing to be overly complex. Below is a basic framework that can get any company through the steps of risk management.

1. Understand your risk tolerance

The first step for any company begins with establishing a philosophy around interest rate risk. There are a number of considerations that will influence this philosophy. It begins with understanding the existing company culture around risk taking and risk management. It is important to note that this may be different for risks such as interest rates, than it would be for risks that relate to a company’s core competency or area of expertise.

Ability to take risk also plays a role, with factors to consider such as leverage or a potential adverse impact on future business decisions. The perspective of key stakeholders is another consideration. Do they see greater value in an expense that fluctuates along with interest rates or one that is predictable over the long-term? It can also be helpful to understand what decisions are being made by companies with a similar profile, or how peer companies manage similar risks. Significant market changes could also put the company at an advantage or disadvantage to its competition.

2. Identify your exposure

A company can start identifying exposure with its most obvious one, existing floating rate bank debt. First you can identify the basic features such as current amount, amortization, maturity, and lender(s).  Note that unless a loan fully amortizes by maturity, its maturity date does not represent an end to rate risk.  It may even introduce additional risks that need to be evaluated. Next, attention can go to more detailed aspects like the benchmark index, day count, and payment dates.  Today, with the developments in the LIBOR transition, it is more important than ever to understand the borrowing index for any floating rate debt.  If it is LIBOR, does your borrowing agreement include fallback language?  Does the agreement include alternative reference rates to LIBOR as an option, such as SOFR, BSBY, Prime, or Fed Funds?  Once debt instruments have been reviewed, your analysis can broaden out to include the entire capital structure, even potentially expanding beyond current obligations, to include future anticipated financing needs.

3. Define your goals

Once a company is comfortable with the evaluation of its interest rate exposures and prioritizes these risks it can then begin to establish defined goals. This can be as simple as determining a desired fixed/floating mix or fixing the rate on debt associated with specific long-term assets.  Some of these goals will likely be near-term, while others more long-term in nature.  Near-term could be to respond opportunistically to rates attractive to the company, by increasing the amount of fixed rate debt.  Long-term goals, like reducing the risk of exceeding borrowing cost targets or project cost budgets, may require a more detailed look at internal financial forecasts and interest rate assumptions.

4. Evaluate your options

Once the assessment is complete, evaluate the various hedging tools available to minimize risk. Consideration can be given to any natural hedges, such as cash on balance sheet that offsets floating rate borrowings or the ability to pass along rising interest rate costs through price increases. This can be tricky because the natural hedge needs to be in place not just now, but also in situations when it would be most needed.

Hedging tools may include the structure through which a company sources funds, such as a debt instrument that has a fixed rate. In some cases, the use of derivative products, such as interest rate swaps, caps or collars, may be the most efficient hedging tool. Being properly educated on the risks and benefits associated with any of these tools is an important part of evaluating them correctly. This step may conclude with documenting a formal or informal risk management strategy/policy.

5. Take action

The final step would be taking any actions needed to fully implement the risk management strategy. This may include reviewing the existing financing structure with the banking team. If the plan is to use derivative products, then it would include putting in place any documentation that would be needed in connection with executing a hedge.

Once a company’s risk management strategy is fully executed it is critical to note that the actions related to interest rate risk management are not done. It is important to continue with a periodic review, evaluating whether a company’s risks, philosophy around risk, or goals have changed. An assessment of any existing hedging tools should be done periodically to make sure they are performing as expected. Finally, it is necessary to remain informed on the latest tools available and developments in market conditions that may warrant a change.

U.S. Bank’s Derivative Products Group is a team of professionals whose resources and expertise in interest rate risk management can be accessed by contacting your U.S. Bank Relationship Manager.

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