What it means
The most obvious form is repricing risk on floating rate debt. A company with a loan priced off a benchmark sees its interest bill rise as soon as the benchmark moves, regardless of how the business itself is performing.
The mirror image affects fixed income assets. When rates rise, the price of an existing bond paying a lower fixed coupon falls, because buyers can get a better yield elsewhere, which is why bond portfolios lose value in a rising rate environment.
There are subtler versions too. Basis risk arises when a loan and the hedge protecting it reference slightly different rates, and refinancing risk arises when a fixed-rate loan matures into a much higher rate environment even though the rate never moved during its life.
Businesses manage the exposure by choosing the mix of fixed and floating debt, by matching the maturity of assets and liabilities, and by using instruments such as interest rate swaps, caps and collars. A swap converts floating payments to fixed, a cap sets a ceiling while allowing the benefit of falls, and each carries a cost.
The nuance worth stressing is that hedging is not the same as winning. A company that fixes its rate and then watches rates fall has paid for certainty rather than made a mistake, and treasury policy should be judged on whether the exposure was appropriate rather than on hindsight.
In practice
Real-world examples
Example 1
A hotel group with $30,000,000 of floating rate debt fixes 70% of it through swaps before a rate cycle turns. When rates rise 3%, the group's extra interest is limited to about $270,000 rather than $900,000.
Example 2
A pension fund holding long-dated bonds sees the value of its portfolio fall sharply as yields rise. Because its liabilities also fall in value for the same reason, the funding position is largely unchanged, which is the point of matching duration.
Example 3
A car dealership finds sales dropping even though it has no debt of its own. Higher rates made customer finance more expensive, so interest rate risk reached the business through demand rather than through the balance sheet.
Think of it
Think of interest rate risk like the weather. Just as a sudden rainstorm can change your picnic plans, a sudden change in interest rates can alter your financial plans, affecting how much you pay or earn.
Formula
Calculation
For fixed income assets the standard approximation is: Change in value = -Modified duration x Change in yield x Current value.
An insurance company holds a bond portfolio worth $10,000,000 with a modified duration of 6.5 years. Market yields rise by 1.00 percentage point, which is 0.01 as a decimal.
Change in value = -6.5 x 0.01 x $10,000,000 = -$650,000.
The portfolio falls from $10,000,000 to $9,350,000, a drop of 6.5%, from a rate move that many people would describe as modest.
For borrowers the calculation is simpler: Change in interest cost = Floating debt x Change in rate.
A distributor carries $8,000,000 of floating rate debt. If rates rise by 2.00 percentage points, the additional annual interest is $8,000,000 x 0.02 = $160,000. If the company's operating profit is $1,200,000, that single move consumes 13.3% of it. Fixing half the debt through a swap would halve the exposure, capping the additional cost at $80,000 for the same rate move.Case study
Seen in the real world
Braxton Cold Storage is an invented refrigerated warehousing business used here as an illustrative example. It financed three new facilities with $25,000,000 of floating rate debt, on the reasoning that floating had been cheaper than fixed for most of the previous decade.
Rates then rose by 4 percentage points over two years. Braxton's annual interest cost increased by $25,000,000 x 0.04 = $1,000,000, against operating profit of $3,400,000. Interest cover fell from 5.7 times to roughly 2.5 times, uncomfortably close to the 2.0 times covenant in its facility agreement.
The board adopted a treasury policy requiring at least 60% of debt to be fixed or capped at all times, and bought a rate cap on $15,000,000 for a premium of $310,000. This illustrative case shows that the purpose of a hedge is not to beat the market but to keep a covenant breach off the table.
Watch out
Common mistakes
- Assuming a business with no borrowings has no interest rate risk, when higher rates can hit customer demand, supplier stability and the value of any cash investments.
- Hedging 100% of floating exposure regardless of the business, which removes the benefit of rate falls and can leave expensive break costs if the debt is repaid early.
- Judging a hedge by whether rates moved the predicted way, rather than by whether it kept the company inside its risk tolerance.
Questions
People also ask
What is duration?
It is a measure of how sensitive a fixed income asset's price is to rate changes, expressed roughly as the percentage price fall for a one percentage point rise in yields.
Should a company fix or float its debt?
It depends on how much rate volatility its cash flows can absorb, and most treasury policies set a target range such as 50% to 80% fixed rather than an all-or-nothing choice.
Does refinancing risk count as interest rate risk?
Yes, because a fixed-rate loan maturing into a higher-rate market raises future costs even though the rate on the original loan never changed.