With the Federal Reserve widely expected to raise short-term interest rates, many borrowers with floating-rate debt are investigating bank tools for hedging against rising rates, including interest rate swaps, caps and, to a lesser extent, collars.
“Many of the restaurant companies we work with are diversifying their interest-rate risk by having some fixed-rate debt and some floating,” according to Larry Kalis, a director in the Rates & Currencies Origination group at Bank of America Merrill Lynch. “Typically these are operators with at least $5 million to $10 million in outstanding debt.”
Deciding if hedging makes sense
Several factors come into play when assessing the appropriateness of hedging interest rate risk, Kalis says. Among them:
1. Degree of leverage.
The greater your debt load, the greater the bottom line impact of a rise in rates.
2. Profitability and balance sheet strength.
A restaurateur that can pay down loans through cash flow, or is in the process of doing so, might be less motivated to hedge. The same holds true for operators who can easily generate cash through the sale of non-vital assets.
3. Industry and company-specific risk factors.
Borrowers with the ability to pass on increases in operating costs may be more comfortable absorbing the impact of rising interest rates than those who cannot.
4. Cyclicality of borrowing needs.
Cyclical cash flows provide a cushion against rising rates.
5. Interest rate environment.
The shape of the yield curve, as well as the absolute level of rates, can affect the preferred debt mix. For example, low long-term rates and higher short-term rates may make locking in fixed rates more attractive than the opposite yield curve scenario.
6. Fundamental risk tolerance.
Some borrowers simply have a stronger desire to minimize uncertainty than others.
Swaps, caps and collars
Let’s take a brief look at the three most popular forms of interest rate hedging.
An interest rate swap is an instrument used to fix floating rate debt when rates are expected to rise, or to change fixed rate debt to floating rate debt when rates are expected to fall. This product is also used by borrowers wishing to eliminate interest rate risk over a period of time.
An interest rate cap is basically an insurance policy against higher interest rates. You pay a premium to cap rates at a certain level for a specified period of time.
And, finally, an interest rate collar combines an interest rate cap and an interest rate floor to create an interest rate “band” within which a company’s cost of borrowing floats. By adding a floor, and forfeiting some of the upside potential of rate movements, you lower your premium costs.
Good time to explore hedging alternatives
“For those restaurant businesses that have not already done so, now is a good time to begin exploring with your banker whether an interest rate hedging strategy makes sense, given your unique requirements,” Kalis says.
- Some restaurant operators are working with banks to hedge against potentially rising interest rates
- Whether interest-rate protection is appropriate for your business depends on several factors
- Working with an experienced advisor can help you identify hedging strategies designed to protect your bottom line