Interest Rate Risk: Managing Debt in a Changing Rate Environment

Interest rate risk is straightforward: when rates rise, your borrowing costs increase. For a company with $5M in floating-rate debt, a 2% rate increase adds $100,000 to annual interest expense. That's real money that comes directly off your bottom line.

The challenge is that rates are unpredictable. Companies that locked in rates in 2021 look smart in hindsight; companies that stayed floating hoping for rate cuts paid the price. The goal isn't to perfectly time rate movements—it's to manage exposure to an acceptable level.

Understanding Your Interest Rate Exposure

Types of Interest Rate Risk

• Cash flow risk: Variable-rate debt means your interest payments fluctuate with rates
• Refinancing risk: Fixed-rate debt maturing into a higher-rate environment
• Basis risk: When your rate and hedge reference different indices

Measuring Exposure

Calculate your sensitivity to rate changes:

In this example, the company has $7M in floating-rate exposure. A 1% increase adds $70,000 to annual interest expense; a 2% increase adds $140,000.

Fixed vs. Floating Rate Trade-offs

Fixed-Rate Debt

• Advantage: Payment certainty—you know exactly what you'll pay
• Advantage: Protection against rate increases
• Disadvantage: Typically higher initial rate than floating
• Disadvantage: Can't benefit from rate decreases
• Disadvantage: Prepayment penalties common

Floating-Rate Debt

• Advantage: Typically lower initial rate
• Advantage: Benefits when rates fall
• Advantage: Usually no prepayment penalty
• Disadvantage: Payment uncertainty
• Disadvantage: Costs increase when rates rise

When to Fix vs. Float

Interest Rate Hedging Instruments

Interest Rate Swaps

A swap converts floating-rate debt to fixed synthetically. You continue to pay floating on your loan but enter a separate contract where you receive floating and pay fixed, netting to a fixed rate.

• Mechanics: You pay fixed rate to counterparty, receive floating rate
• Result: Your net interest expense is fixed
• Cost: No upfront payment; you "pay" through the fixed rate
• Flexibility: Can be unwound, but may have termination value

Interest Rate Caps

A cap limits your maximum interest rate. You pay floating unless rates exceed the cap level, at which point the cap pays you the difference.

• Mechanics: Buy protection at a "strike" rate (e.g., 5%)
• Result: Your rate can't exceed strike + your spread
• Cost: Upfront premium (typically 0.5-2% of notional)
• Flexibility: No obligation—can let expire

Interest Rate Collars

A collar combines a cap (protection) with a floor (giving up downside). The floor premium offsets the cap premium, reducing or eliminating net cost.

• Mechanics: Buy a cap, sell a floor
• Result: Rate stays within a defined band
• Cost: Reduced or zero net premium
• Trade-off: Give up benefit of rates falling below floor

Comparing Instruments

Implementation Considerations

How Much to Hedge

• Consider hedging 50-75% of floating exposure to balance protection with flexibility
• Leave some floating for prepayment optionality
• Don't hedge more than you expect to borrow (over-hedging creates risk)
• Match hedge tenor to expected debt paydown schedule

Working with Banks

• Your lending bank often executes hedges—convenient but may not have best pricing
• Get competitive quotes from 2-3 banks
• Understand credit requirements (ISDA documentation, collateral)
• Consider independent hedge execution if substantial enough

Accounting and Reporting

• Hedge accounting allows matching P&L timing of hedge with underlying debt
• Requires formal documentation and effectiveness testing
• Without hedge accounting, derivatives marked to market through earnings
• Report hedge portfolio to leadership—show effective rates, not just stated rates