Eight risk management ideas for the end of QE
Rising interest rates, wider credit spreads and higher yields on risk assets are some of the potential impacts on global markets when Quantitative Easing starts coming to an end, writes Eu-Jin Ang, Senior Director, Corporate Advisory, RBS.
There are arguments that tapering QE does not mean an abrupt turning off of the monetary taps and should be seen as a positive sign of recovery. However, reactions to US Federal Reserve chairman Ben Bernanke’s comments, when he discussed the issue earlier this year suggest the markets might not take the move calmly.
1. Consider locking in current levels of interest rates for future debt issues by pre-hedging. Look to hedge bond issues farther out in time than usual – perhaps between one to three years ahead, rather than the more typical time of up to three months.
Investigate instruments such as forward-starting interest rate swaps, treasury / gilt locks, swaption collars or purchased swaptions. These can be structured and documented to qualify for hedge accounting without the need to match the refinancing of existing bonds or bank debt. Pre-hedging saves on the cost of carry of pre-funding debt maturing in the future, though it may have costs of its own.
2. Credit lines, documentation and other logistics need to be in place when swap rates rise to a level where companies want or need to re-institute fixed-to-floating debt ratios specified by treasury policies.
Many firms now have too much fixed-rate debt under their strategic risk management policy limits. With fixed rates near historical lows and strong investor appetite for credit assets with tenor, the savings made from floating-rate debt versus fixed have been lower than usual. This has encouraged firms to leave bond issues unswapped. Cyclical sectors, such as natural resources, have the biggest gaps because they typically adopt a 100 per cent USD floating debt long-term benchmark.
3. Consider ‘paid-to-wait’ forms of fixed-to-floating hedges. Corporates are paid up front for selling a short-term interest rate swaption. When exercised, this option would put in place a fixed-to-floating swap with a receivable swap rate that is better, or higher, than in today’s market. Even without the option this market level might be one at which the firm would have stopped waiting and chosen to execute an IR hedge, but it has reduced its debt costs through the upfront payment.
4. ‘In Arrears’ resets on floating interest coupons could help as yield curves become steeper in a tapering or post-QE environment. In Arrears rate settings, typically enacted via Libor-in-Arrears swaps, refer to floating rates at the end of the coupon period. A steeper yield curve means this will be higher than at the start of the period, which is more typical of In Advance fixings. The margin added to floating rates for In Arrears coupons is lower than margins for In Advance coupons. If rates rise as per the yield curve, there will be no present value gains or losses. However, if rates rise more slowly, then benefits accrue from the reduced floating margin.
5. Re-visit FX hedging strategies and hedge ratios. Currency volatility may have dampened between countries practising QE, contributing to lower levels of corporate FX hedging in recent years. But at the same time FX hedging costs have fallen because near zero interest rates in QE countries lead to small interest rate differentials and FX forward carry costs. Many companies have not been taking advantage.
With tapering on the agenda, it may no longer be the most opportune time to correct any FX under-hedging. However, hedging soon could still prove prudent. As QE is tapered or reduced in some countries but not in others, interest rate differences may start to widen and increase FX carry costs and perhaps currency volatility too.
6. With FX volatilities not far from post-crisis lows, companies could think about putting on option-based hedges. Options may provide a flexible form of FX hedging, especially for uncertain exposures, and it may be worthwhile paying for this if a post-QE world is a less predictable one.
Out-of-the-money options or zero premium collars may have a place in the firm’s armoury as low-cost disaster protection against low probability but high-impact events, such as a euro break up, emerging market currency crises or mass unwinds of global carry trades when QE ends.
7. Entities whose revenues are inflation-linked could think about locking-in future earnings uplifts by using revenue / income inflation swaps. QE tapering or ending is expected to temper inflationary pressures and lower market expectations for future inflation and hedging levels, as well as increase the likelihood of low inflation or even deflation. This could be painful. However, this effect is likely to be muted by the economic improvement that drove the central bank’s decision to taper QE in the first place.
8. Issuing nominal debt and swapping it into an inflation-linked liability. It could also allow such companies to benefit from current medium-to-long-term inflation expectations still remaining relatively high while real rates are historically low and attractive.
No representation, warranty, or assurance of any kind, express or implied, is made as to the accuracy or completeness of the information contained in this document and no member of the RBS Group accepts any obligation to any recipient to update or correct any information contained herein. This document is published for information purposes only and does not constitute an analysis of all potentially material issues. Views expressed herein are not intended to be and should not be viewed as advice or as a recommendation. You should take independent advice in respect of issues that are of concern to you.
This document does not constitute an offer to buy or sell, nor a solicitation of an offer to buy or sell any investment, nor does it constitute an offer to provide any products or services that is capable of acceptance to form a contract. The products and services described in this document may be provided by any member of the RBS Group, subject to signing appropriate contractual documentation. No member of the RBS Group shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this communication.
The Royal Bank of Scotland plc (RBS plc) is registered in Scotland No. 90312 with its Registered Office at 36 St Andrew Square, Edinburgh EH2 2YB. It is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal Bank of Scotland N.V. (RBS NV) is authorised by De Nederlandsche Bank and is regulated by the Autoriteit Financiele Markten for the conduct of business in The Netherlands. RBS plc is in certain jurisdictions an authorised agent of RBS NV and RBS NV is in certain jurisdictions an authorised agent of RBS plc.
RBS plc or RBS NV is authorised and regulated in Hong Kong by the Hong Kong Monetary Authority, in Singapore by the Monetary Authority of Singapore, in Japan by the Financial Services Agency of Japan, in Australia by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority ABN 30 101 464 528 (AFS Licence No. 241114) and in the US by the New York Department of Financial Services, the State of Connecticut Department of Banking, the Federal Reserve Bank of Boston and the Board of Governors of the Federal Reserve System. In the United States, securities activities are undertaken by RBS Securities Inc., which is a FINRA/SIPC member and a subsidiary of
The Royal Bank of Scotland Group plc.
Copyright 2013 RBS plc. All rights reserved. The daisy device logo, RBS, and The Royal Bank of Scotland are trade marks of RBS plc and the RBS Group Members. This communication is for the use of intended recipients only and the contents may not be reproduced, redistributed, or copied in whole or in part for any purpose without RBS’s prior express consent.