Of all the risks that business leaders must consider, the impact of volatile interest rates on their floating rate debt payments should be top of mind. Yet many mid-size companies don’t realize they could mitigate these risks. And, they should do so before future hikes bring an end to record low rates.
Fortunately, Scotiabank delivers interest rate hedging strategies to Commercial Banking clients - from manufacturers and farmers to any business with tight margins threatened by rate changes. Locally led advisors demystify hedging products, for clients who are ‘on the fence’ about fixing their debts or need a swift solution when business priorities shift.
If you wait, it may be too late
“Business owners worry about rates when they ‘sign on the dotted line’ for a loan, but they often don’t consider hedging options to mitigate that stress,” says Scott Morrison, Managing Director and Head, Commercial Derivative Products Group and Foreign Exchange Sales.
“In contrast, the best hedgers do so at the onset of the loan. We help them forecast their cash flows over the coming years, budget for their principal and interest rate payments, and then find ways to stabilize their borrowing costs to align with their budgets and forecasts.”
““Many borrowers assume they only have two choices - a fixed or floating rate - but we use capital markets instruments to combine those features and provide the client with great flexibility.”
Arnold advises agricultural clients across Canada about their interest rate risks, and the opportunities to apply hedging techniques customized to their loans and precise needs.
And the risks are real, notes Brittany Owens, Director, Commercial Derivative Products Group: “Imagine a client who has a $5 million loan. If interest rates rise 1.5 per cent, that’s roughly $75,000 per year in added interest expense, which can eat away at their bottom line.”
That’s especially pertinent today, adds Owens: “Our economists recently forecast that the Bank of Canada could start to hike rates by the third quarter of 2022. If you consider that a typical rate increase is 25 basis points - and historically six increases have occurred per rate hiking cycle - a borrower with floating rate debt could see a 150-basis point increase in the near future.”
Unfortunately, many companies ‘sit on the fence’ even when they hear of likely rate changes. Says Arnold, “It’s been almost a year since the last interest rate shock, so many people have become accustomed to low floating rates. They think they can ride out the current rates until they start to move. However, if you wait, it’s likely going to end up costing a lot more for a fixed rate in the future.”
“Once you read about a rate hike in the newspaper, it’s almost too late to act because the higher risk factors are already priced into the markets,” affirms Morrison. “It’s smart to be a contrarian and recognize that rates are low right now for a reason, so make an informed decision today rather than wait.”
Take guesswork out of rate decisions
“Our clients are busy running their businesses so they may not have time to think about future interest rate movements,” says Arnold. “However, any company with any type of debt, including operating facilities or term loans or leases, is exposed to interest rate risk, especially industries like agriculture where margins are tight.” She describes how dairy farm clients must carefully manage their interest rate costs since their revenues are fixed based on set quota prices for milk. Thus, rising debt payments could spoil their profits.
“The most important thing is that we get in front of our clients to make them aware of these risks,” asserts Owens. “We provide clients with market updates and talk about possible hedging strategies. For example, when clients learn they can lock in for five years at a rate lower than they were floating at in February 2020, pre-pandemic, many find that very appealing and are deciding to lock in and hedge a larger portion of their debt given the current low interest environment. We work with clients to determine their optimal hedging strategy to meet their near- and long-term financing goals.”
Scotiabank’s Derivative Products Group thoroughly explains the benefits of using capital markets tools, like interest rate swaps and options customized to a client’s loan. Among them, these hedging products provide flexibility not available through conventional fixed rate loans, including portability among other loans or lenders and preferential ‘break costs’ if the borrower chooses to pay down or revise their lending strategy later.
“Many clients assume that interest rate hedging is only for big corporations,” says Arnold. In fact, some clients have only heard about the infamous, high-risk derivative products used by Wall Street investors. However, such derivatives are very different from those widely used to manage commercial interest rate and FX risks.
“When we explain how hedging works, they are amazed that they can fix their debt and sleep at night, knowing what rate they will pay for the next five to 10 years,”
She notes that they also encourage clients to develop a formal interest rate hedging policy to take the guesswork out of future rate decisions.
Owens emphasizes that, Scotiabank has a unique advantage over other banks that provide derivative services to mid-size companies: “We deliver these solutions through our local Commercial Banking Relationship Managers, so a client in Moncton or Red Deer can deal directly with the trusted local banker they’ve known for years. Other banks could require a client to deal only with a Bay Street banker to access these products.”
Owens points out that Scotiabank’s Derivative Products and FX Specialists also travel extensively to meet face-to-face with clients alongside their local Relationship Managers:
“We accompany our client on the whole journey and keep them top of mind throughout the year, so we can consider new ways to structure their hedge for the latest rate environment. During the pandemic, we worked extensively with clients to restructure their hedges to best meet their needs in unprecedented times.”
So glad they ‘fixed’ when they did
Anyone who still doubts the value of hedging their interest rate risk should talk to a company that has either learned the hard way, or the right way. For example, Morrison describes a major manufacturer that today faithfully ‘fixes’ every loan commitment: “Back in the 1980s their very first loan was a floating rate product. When interest rates spiked, they had to sell the family home to keep up with the loan payments. That experience convinced them to make rate hedging ‘part of their DNA’, and now they are an incredibly successful company.”
Arnold recalls a client who was grateful for Scotiabank’s proactive advice when they were planning to increase an existing $5 million loan. “The client wanted to wait a few months, until they completed the final draw and could put a hedge on the larger loan they were arranging. However, we reminded them that rates could shift drastically in just a few months. Fortunately, they decided to lock in the bulk of their existing debt at that point. Today, they are so glad they did because their final debt draw was delayed and interest rates rose abruptly. Now, they are practically ‘hugging us over the phone,’ because we helped them lock in a really good rate for the majority of the loan balance. Additionally they can restructure the existing swap to add in the incremental debt when the final draw takes place, and this will keep their hedging structure very simple.”
Morrison marvels at how the market has evolved in recent years:
“In the past, these financial tools were exclusively for multi-national corporations, and now, thanks to competitive innovation, technology and the growing sophistication of business operators, a company with approximately $5 million in debt can benefit from these same products.”
Whether it’s business big or small, it comes down to a friendly conversation with a client about their needs, conclude Arnold and Owens:
“These business owners have built successful companies, so we just need to understand their goals, their market views, and the risks they face. Then, we can show them how an interest rate hedge can help manage those risks, create flexibility for whatever’s down the road, and grow their business to the next level.”