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Treasurers, Time to Develop Your Interest Rate Strategies

  • By Amol Dhargalkar
  • Published: 3/1/2016

amol2Dunkin’ Brands, Vantiv and Bloomin’ Brands spoke on a panel with Chatham Financial at the 2015 AFP Annual Conference to discuss their firms’ approaches to interest rate risk management, covering topics as diverse as strategy development, hedge accounting, legal and regulatory compliance, and trading. The trio left the audience with a key message: be proactive in developing your interest rate hedging strategy and recognize that the interest rate derivatives market has changed significantly in the last several years.

Implementing an interest rate hedging strategy

Interest rate risk is always present within a capital structure, and many firms have targeted certain fixed rate percentages within their debt portfolio to help support their interest rate risk management decisions. For example, Gina Powers, assistant treasurer at Dunkin’ Brands, shared that at one point, her company had an all floating rate debt capital structure. The company was uncomfortable with the significant amount of interest rate risk that could impact reported earnings per share, and as a result Dunkin’ executed a set of pay-fixed interest rate swaps to reduce the risk by about 50 percent. Subsequently, Dunkin’ has refinanced its entire debt capital structure into a fixed rate securitization and has removed all floating interest rate risk from its debt portfolio.

Even when a firm decides to reduce its interest rate risk, it must select the appropriate strategy from a limitless set of alternatives. Most companies work with their relationship banks to at least get a sense of the alternatives. Tim Cooper, treasurer at Vantiv, shared that he received proposals from his banks on various structures for hedging, along with ideas on how best to execute the transactions. Paul Kirby, director of treasury operations at Bloomin’ Brands, said that it was a difficult decision to hedge, given how low rates were. Nevertheless, his company eventually decided to hedge to reduce the risk of future rate hikes rather than try to take a view on where interest rates would go in the future.

One of the constraints that firms face around their hedging strategies is the application of preferred hedge accounting treatment under ASC 815 (formerly known as FAS 133). If an interest rate derivative is structured and documented appropriately, quarterly gains and losses on the hedge can be deferred into Other Comprehensive Income in equity on the balance sheet, rather than taking the gains and losses directly through the income statement.

Additionally, applying “good” hedge accounting treatment leads to greater stability of the interest expense line item. Nearly 90 percent of public companies apply “good” hedge accounting for their interest rate derivatives. All three firms suggested that treasury professionals should be sure to bring their colleagues on the reporting side into the hedging conversation(s) early, and to work with experts and auditors early on documentation around the hedge(s).

In order to execute an interest rate derivative, all three firms had to negotiate International Swap and Derivatives Association (ISDA) agreements and comply with Dodd-Frank requirements. Notably, the ISDA Master Agreement is a standardized document, but the ISDA Schedule that elects the terms for the specific relationship is not. Each bank has a different set of issues that ultimately impact the attractiveness of the documentation to a corporate end-user. Although this process could take as long as three to six months, all of the panelists were able to put their ISDAs in place relatively quickly with the support of outside experts.

Finally, executing a derivative transaction provides the opportunity for treasurers to reward relationship banks with ancillary business. Each of the panelists executed transactions with their relationship banks that provided the best combination of legal terms and pricing. Pricing efficiency was incredibly important to each of the companies, and as a result not all relationship banks were awarded (a portion of) the derivatives business.

Implementing an interest rate hedging strategy requires companies to evaluate many alternatives, prepare legal and regulatory documentation, and ultimately execute transactions in a cost-effective manner while balancing close banking relationships. As the Fed continues to raise rates in the face of an economic recovery, many firms will need to adjust their approach of enjoying zero percent interest rates and the lessons of the panel may prove quite valuable to others undertaking similar discussions.

Amol Dhargalkar is a member of Chatham’s Operating Committee and leads the Global Corporate Sector serving public and private corporations focusing on interest rate, foreign currency and commodity risk management.

A longer version of this article will appear in an upcoming edition of AFP Exchange.

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