interest rate risk and refinancing risk

1 August 2009

The ACT tends to take to look at the two subjects of interest rate risk and refinancing risk in separate buckets.

Thus when we talk about interest rate risk we usually talk about the risk in the movement in benchmark rates, such as LIBOR or treasuries or gilts, and the effect of those on one or more of three things, namely the interest income or expense, or the effect on interest bearing assets and liabilities, such as pension scheme bond assets or pension liabilities, or the effect on the business economically caused by rising or falling rates.

And when we talk about refinancing risk we tend to talk about the availability of finance at the maturity of existing facilities, as for example whether certain markets might be open for lending or as to what financial state the borrower might be in, measured perhaps by typical credit ratios such as interest cover or Debt as a multiple of EBITDA. Clearly if all markets are open and the borrower has stable and good credit ratios, then the refinancing risk is lower.

What is possibly missing in this analysis is the risk of a movement in borrowing margins over time which is reflected in an interest rate but usually happens when a firm is refinancing.

Thus a firm with floating rate borrowings and a margin of 50bp under a current facility might be paying 1.50% if LIBOR is 1%. It has a risk on the LIBOR and a risk on the margin. Under current conditions it is very likely that the margin will increase on a refinancing, notwithstanding any credit issues on the part of the borrower, simply because margins generally have risen during the credit crunch. So this risk is part interest rate risk, part refinancing risk.

There are some tools to manage this risk, as part of a risk framework. Firstly a banking product has come onto the market in recent months, called a Forward Start Facility. This is designed to meet the refinancing of an existing maturity. It is likely that margins will rise from current levels, on both the new and Existing Facility, but they will of course be fixed until the end of the new facility.

Secondly it is possible to hedge margins generally by using Credit Default Swap indices, such as those operated by iTraxx. Thus if it was expected that margins might generally rise up to a refinancing, then indices might be sold and bought back cheaper at the time of refinancing. This type of hedging might be quite difficult for many corporates.
Finally a firm can trade its own Credit Default Swap, if a liquid market in it exists, in a similar fashion to trading indices.