In our previous article from December 2023, we explored why a company might use an Interest Rate Swap (IRS) to fix its borrowing costs for a set period. We explained that companies might choose to hedge with an IRS if they want to stabilize their borrowing costs for a foreseeable future. An extra motivation can be the anticipation that future short term interest rates would be higher than the market currently expects (based on the forward rate curve).
On December 10th, 2023, companies had the opportunity to lock in a fixed interest rate of 2.72% for the next five years by purchasing a 5-year IRS (see Chart 1). So, how have market expectations for interest rates evolved since then?
Chart 1
The market currently expects short term interest rates to remain elevated for a longer period than anticipated in December 2023 (see Chart 2). Initially, the lowest interest rate was expected in December 2025, around 2.25%. The 3-month EURIBOR rate at the end of the 5-year IRS was also projected to be around 2.5%. However, as of June 10th, 2024, the market now expects the December 2025 3-month EURIBOR rate to be 2.88% and the end-of-term 3-month EURIBOR rate for the 5-year IRS to be 2.51%. The 5-year IRS is at 2.95% on June 10th.
Chart 2
Based on current expectations, companies that hedged a portion of their debt with a 5-year IRS in December would have been better off than paying the variable market rate represented by the 3-month Euribor. However, it’s crucial to remember that:
– Hedging is Strategic: The decision to hedge should be part of a company’s overall financial strategy, considering its financing structure and asset maturity. Today hedging generates a positive carry (due to LT rates being lower than ST rates), which leads to an immediate positive cash-flow impact for investors.
– Market Predictions are Uncertain: Market expectations rarely align perfectly with reality. The future may unfold differently than current forecasts (reflected in the forward curve). For example, the European Central Bank’s decision on June 6th regarding a 25-basis point cut of their reference rate marginally impacted the markets as it was expected. However, their more cautious tone regarding future rate cuts due to remaining inflation pressures had a greater impact.
Conclusion:
While hedging with a 5-year IRS in December 2023 appears favorable today based on current market evolutions, it’s vital to consider the long-term strategic implications on your financing strategy and the inherent uncertainty associated with market predictions.
So, what’s your take? To hedge or not to hedge?
At Ernest Partners we advise companies in the search for financing for their projects, this includes developing a relevant hedging policy.
