As the U.S. economy begins to recover in the wake of the COVID-19 pandemic, the historically low interest rates we’ve seen will begin to rise. In fact, long-term interest rates are already on the increase following the passage of the latest stimulus package. A recent Kiplinger report predicts that the 10-year interest rate will grow by 2% by the end of this year, and mortgage rates will bump up as well.
Rising interest rates can represent risks to investors, specifically impacting the value of fixed-income securities. A rise in interest rates causes bond prices to fall, making bond investors vulnerable to losses. Additionally, as interest rates go up, the costs of borrowing money go up as well. This can make corporations more hesitant to take out commercial loans, resulting in less spending, less growth, and ultimately less profit.
Investors interested in mitigating the risks associated with rising interest rates may want to consider the following hedging strategies.
- Forwards – A forward contract is a custom contract between two parties to buy or sell an asset or commodity at a specific price at a future date. This is a basic hedging strategy to help ensure you get the price you want regardless of interest rates in the future.
- Forward Rate Agreements (FRA) – Forward rate agreements are contracts that use a formula to determine what interest rate will be paid on an agreed-upon date in the future. For example, a borrower can fix the costs of a loan by entering into an FRA.
- Futures – A futures contract is similar to a forward, but it is a legal agreement that obligates the parties to buy or sell an asset or commodity at a specific price at a future date. Futures represent less risk than forwards because they are standardized and involve an intermediary.
- Swaps – An interest rate swap is a forward contract that exchanges one stream of future interest payments for another based on a specific principal amount. For example, a swap may involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce exposure to the fluctuations in interest rates.
- Options – Options, typically bought and sold through brokers, are financial derivatives based on securities that give buyers the option to buy or sell an asset at an agreed-upon price and date. Unlike futures, the buyer is not obligated to buy or sell the asset – they are given an expiration date by which they must choose whether or not to exercise their option.
- Caps – A cap, also known as a ceiling, is an interest rate limit on a variable rate credit product (such as an adjustable-rate loan). It is the highest possible rate a borrower will have to pay or a lender can earn.
- Floors – An interest rate floor is the opposite of a cap – it’s the lowest possible rate a borrower would have to pay or a lender could earn.
- Collars – A collar, also known as a hedge wrapper, is when someone simultaneously buys a cap and sells a floor or vice versa. This hedging strategy can help protect against significant losses but will also limit gains.
Bottom line: there are a number of hedging strategies that can protect investors and mitigate risk as interest rates begin to rise. Interested as to which financial instrument best meets the needs of your business and can protect your assets in the future?