Should investors be looking at hedging strategies?

Despite many false starts, the BoE has not yet been compelled to reverse this. Ongoing Brexit uncertainty provides the latest reason for the prolonged use of such ‘emergency’ measures. Low interest rates are increasingly a source of frustration for Mark Carney, who is hampered from responding to the underlying inflationary pressure that a red-hot labour market brings.

With unemployment at a 44-year low of 4% and still falling, central banks’ models would suggest it is only a matter of time before workers are granted the real wage growth that their scarcity demands. A Brexit deal that appeases businesses’ concerns would potentially empower workers further. Such a deal, if attainable, would likely be the catalyst for the BoE to tighten monetary policy in anticipation of future inflation. In turn, leveraged real estate investors could see returns adversely affected by rising debt costs.

While any hedging strategy should be tailored to an investor’s business plan and financial covenants, the prevailing flat yield curve provides a potential opportunity. This is particularly true for longer-term investors focused on income, who might be more receptive to inflexible strategies such as swaps.

First, tenor can be achieved on debt and hedging solutions at a marginal cost: five-, 10- and 20-year swaps are currently trading at 1.12%, 1.28% and 1.43% respectively. Many investors have already been quick to take advantage by increasing their debt maturities with longer-dated institutional fixed-rate debt that references swaps or gilts.

Second, the cost of carry, or difference between the contracted swap rate and prevailing Libor, is at a historically low level (0.22% for a five-year swap, excluding credit charges). This is the lowest level since October 2016. Admittedly, it would increase were the BoE’s rate to fall. However, with the scope for interest rate rises arguably larger than that for falls, one could assert that the cost benefit is favourable.

The combination of these factors makes swaps relatively attractive in comparison with flexible strategies such as caps. A corollary to this is that Libor would have to drop to a pessimistically low level in order to recoup the cap premium and make this strategy economically preferable to a swap. That said, investors with business plans that require flexibility should not necessarily be put off.

Those sceptical of hedging given the markets’ tendency to overestimate future interest rates certainly have a case. However, as demonstrated in recent years by US markets, when central banks undertake a tightening cycle, the markets can be just as guilty of underestimation.

For our US clients, suitable hedging strategies have been instrumental in protecting financial covenants and enhancing investor returns. This could prove to be particularly welcome if future rate rises adversely affect real estate yields and cap rates.

Shane Canavan is a director at JCRA