Company XYZ Pty Ltd borrows $50m from their financier to buy out a competitor. This debt is deemed to be long term.
Interest rates are at historical lows with expectations that they will rise in the near future.
The company does not have a hedging policy but believe it is prudent to put some hedging (risk management solution) in place.
At current variable rates of 3.50%, the debt costs $1,750,000 per year to service (excluding the Financiers margins and fees). Should rates rise by 1.00%, it will cost XYZ an extra $500,000 per year in interest costs to service this loan. This may have a serious impact to the profitability and sustainability of the company.
The long term yield curve is offering fixed rates for 5 years at 5.00%. Most forecasters are predicting that interest rates will rise to 6.00% in 18 months time. It would therefore appear prudent to FIX the debt for 5 years.
The answer here is not a simple YES or NO. There are a large number of alternative structures available and it is only with a cost/benefit analysis of the other alternatives that an informed decision can be made.
Buying an Interest Rate Option, namely an Interest Rate Cap, provides the benefit of paying lower rates now and 'capping' out the exposure should rates rise. Simliar to other insurance there is a premium payable. This may prove cost effective in the long term.
It is imperative that all alternatives are weighed up against each other and an informed decision be made at the inception of any risk mangement positioning. It is also imperative that this position is monitored for effectiveness and usefulness on many occasions through its life.
