Interest Rate Risk Management – Hedging - Caps, Collars & Swaps

The topic of interest rate hedging is becoming increasingly more discussed in current market conditions. Many borrowers have found themselves with no option other than to remain on a Lenders Standard Variable Rate (SVR), due to criteria, limited lending options and loan to value (LTV) restrictions narrowing the refinancing market to an unwelcome low.

With Businesses, Professional Landlords and residential owners unable to adjust their borrowing exposure to a product or Lender to suit their business plan and attitude to risk, stand alone Interest Rate Management products such as Caps, Collars and Swaps become a suitable alternative. 

What is Interest Rate Hedging?

In brief: Interest Rate Hedging is minimising and maximising your exposure to interest fluctuations by entering into a financial derivative. When considering your residential, business or portfolio mortgage debt, different strategies will need to be applied that protect your exposure within a defined period,

How can it apply to me? 

Interest rate risk management products can be used by businesses or individuals. Banks normally apply certain restrictions to the availability of these products as they can be viewed as high risk and the area of ‘advice’ surrounding such products can be a regulatory nightmare.  

Residential Mortgage Owner

In the same way that your mortgage Broker or Financial Adviser will discuss the available mortgage product options such as fixed or tracker rates, interest rate hedging products can use certain aspects of these choices to suit your budget and attitude to risk. You may have wished to take advantage of current low interest rates, but were fearful that should they rise your mortgage payments would increase beyond your budget. In such circumstances a stand alone ‘base rate cap’ could protect your payments at your chosen level, but you would still be able to take a tracker product of your choice to take advantage of low interest rates, for as long as they last….

Professional Landlords and Investors

With Bank Base Rate at its current low you are no doubt tempted to take advantage of the tracker rates around that provide pay rates as low as 3.5%.  This might be great news now, but you are of course aware that when interest rates inevitably return to a more ‘normal’ level the margins applied to the current products will result in a much higher rate than. A current tracker rate of 3.5% applies a margin of 3% over Bank Base Rate. If BBR should increase to 5% which is by no means unlikely, the resulting 8% pay rate could certainly impact on the yield of your portfolio to a critical level.

In the current climate with money still coming at a price, the Fixed rate options are by no means attractive and it therefore leaves the decision making of managing your portfolio a tough one at present.

Businesses

If you have a large business loan, you will be able to apply quite simple maths to know at what point increasing interest rates will make your payments unsustainable and therefore threaten your business. Alternatively, you may also know that currently the payments on your business finance actually leave a level of positive cash flow that could be put to better use. Many Business owners will apply an interest rate cap to ensure their payments do not reach a critical level. The cost of such a policy can be offset by applying a collar so that if their payments reach a certain floor (low), a premium is reversely payable.

Can’t Refinance?

With reduced loan to value (LTV) products across the buy to let market, many investors have no options when it comes to remortgaging at present, as the current loan will exceed the maximum LTV limits on the products available. Short of reducing the loan or taking in some cases a product switch (if the Lender will allow), your borrowing remains in the hands of the prevailing interest rates, and therefore leaves an unwelcome level of uncertainty.

What can be done?

Interest Rate Management Products can alleviate the above issues by allowing you to effect a policy that suits your individual requirements, risk profile and affordability. With a large portfolio and the differing margins and variable rates spread across the products it can sometimes take detailed analysis to calculate at what point interest rates would make sustaining your portfolio critical.

Using the services of an Independent Analyst can assist you make an informed decision of when prevailing interest rates would impact your investment to a critical point. Alternatively, you may already understand the level of increase required in Bank Base Rate that would result in negative cash flow or unsustainable mortgage payments.

If you do decide to enter into a derivative, think carefully before you do so and understand the pitfalls as well as the benefits. The question of when is the ‘right time’ can never been answered, particularly in today’s uncertain global financial climate.