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Professional gamblers like to hedge their bets. So do sub-investment grade CFOs — but while they’re typically more conservative than your average high-roller, some are now betting big on a decline in base rates by unwinding hedges on their floating rate debt. 

The rate outlook is still hotly debated, but concerns over the health of the economy may have accelerated the timeline for the Fed to stop hiking and maybe even start cutting.

Rising rates have eaten into loan issuers’ interest coverage ratios, and new deals are becoming prohibitively expensive. Against this backdrop, a decline in SOFR would provide much-needed relief to loan borrowers — but only if they haven’t already fixed their coupons via hedges.

“Deals today are painful, but companies know that it is floating rate and if forward rates are lower in two years, they’re going to benefit from that,” said Scott Roberts, president of Belvedere Direct Lending Advisors. “The question for a lot of these borrowers is: how much of that floating rate exposure do you hedge?”

This puts CFOs in the unenviable position of trying to guess the timing and trajectory of Fed policy.

SOFR still rising (via Federal Reserve Bank of NY)

For any borrowers that choose to roll back hedges — or simply not renew them — in the hope that rates will come down, there’s always the risk that the recent banking crisis blows over and the Fed continues raising rates to combat inflation. 

In that scenario, companies without hedges could get stuck paying higher interest costs, at a time when free cash flow and interest coverage are already getting stretched thin. 

“It’s a real risk,” said a portfolio manager. “Based on my conversations with CFOs, maybe only one in four are between 50%-80% hedged on their floating rate exposure.”

Standards vary, but a good baseline is that levered borrowers are generally encouraged to hedge half of the dollar amount of the loan. But that’s changing. 

“Companies are requesting to have less hedging to capture some of the upside that they see in the marketplace,” a leveraged finance syndicate banker told 9fin. 

“They don’t want to necessarily lock into what they perceive as being a high level, and so the sponsors are hoping to have a bit more flexibility with respect to the maximum they would have to hedge.” 

Some companies may also opt for shorter hedging arrangements in the current market environment. 

Typically borrowers will hedge their floating rate exposure for six-month, one-year or two-year periods, depending on their view on rates and how much flexibility they want. Last year, many companies opted to lock in longer hedging periods. 

But today, CFOs who are hedging out exposure on recently issued loans — or that have existing hedging contracts coming up for renewal — may opt for shorter periods and more flexibility, sources said.

In the near term, raising new funding in the leveraged loan market is still going to be an expensive endeavor. 

Today, 30-day, 90-day and 180-day backward-looking SOFR averages are at all-time highs, according to data from the New York Fed. On top of that, average leveraged loan spreads are still elevated. 

A more nuanced picture emerges if you look at projected SOFR futures. And this could provoke some optimism among borrowers with refinancing needs, as it implies lower coupons in the months and years to come. 

SOFR futures came down in late March (data via CME Group)

Markets are currently predicting that SOFR will continue to climb from today’s levels. Forward-looking CME term SOFR rates suggest that SOFR averages could rise to 4.89% over the next three months, up from the current average backward-looking three-month average of 4.5%. 

However: those expectations are lower than the 5.5%-6% peak that markets were predicting before the recent banking crisis. Markets are also predicting that the peak will come sooner than previously expected, and that rates will continue to fall to near 3.5% by this time next year. 

All else being equal, the promise of lower rates could spur a slight increase in primary loan market activity, sources said. But without knowing how the broader economy will be impacted, it’s unlikely this trend alone would significantly accelerate primary issuance. 

And from the buyside perspective, while lower rates mean less interest burden on borrowers, they also mean a lower return. 

“It’s a double-edged sword for investors,” said another buysider. “High interest rates are certainly causing some pain for certain borrowers in the short term, and to see them move lower would be positive for the health of these credits. But as investors, it means less interest for us.”

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