5 Effective Ways to Hedge Interest Rate Risk

By Scott Roberts

With rumors of rate increases swirling, it is important both firms and individual investors consider how interest rate risk will affect their portfolios. Interest rate risk is something that cannot be ignored, as common assets like bonds and loans are extremely vulnerable to the impact of rate changes. A rise in interest rates can cause some bonds to become essentially worthless, so it is critical investors understand how to strategically hedge the interest rate risks in order to protect their investments. This article will highlight who is susceptible to interest rate risk, what type of investments are most exposed, and effective ways to hedge against this type of risk.

Before we dive into some great hedging strategies, it is important to understand when and why hedging is necessary. Whether you are working for a lending firm, investment bank, or are simply a retail investor, interest rate risk is relevant to your investing. Lending firms and banks are most exposed to interest rate risk when lending, specifically when it comes to fixed rate loans like mortgage loans. Besides lending, financial institutions can face interest rate risk when investing in bonds. Just like these big financial institutions, the average investor can also be exposed from making bond purchases. In particular, fixed-rate bonds with longer maturities face the most exposure. This is because there is a longer period of time in which interest rates could rise unfavorably, which would decrease the bonds value.

Now that the need for hedging has been established, it is important to explore the most effective hedging techniques, as well as understand when each one is most effective.

Having a diverse arsenal is great, but knowing when to use each weapon makes you even more powerful.

First, let’s evaluate how shortening maturities could hedge against interest rate risk. A common strategy to hedge against rising rates is selling long term bonds and purchasing short term bonds. This allows investors to greatly shorten the exposure of their investments without giving up too much yield.[1] For lending firms whose lending portfolio is made up of mostly long-term fixed rate loans, it is a good strategy to hold short term assets in their investment portfolio, as mentioned above. Balancing a long-term focused lending portfolio with a short-term focused investment portfolio provides added liquidity and a source of income for lending firms.[2]

Building on this short-term strategy, floating rate bonds are an effective way to use increasing rates to your advantage. Bonds with variable rates adjust periodically, which protects investors from being stuck with an unfavorable rate for a long period of time. However, it is worth noting that investors sacrifice some yield in order to gain the security these floating rate bonds provide.

Another effective hedging strategy involves futures. During times like this when interest rates are expected to rise, a common hedge is buying interest rate futures. These trades enable investors to lock in on a certain interest rate in order to hedge portfolios.[3] Forward rates are also commonly used by investment firms to hedge, but futures offer less risk in terms of default and liquidity due to the inclusion of an intermediary.[4]

It is also important to consider the different causes of interest rate risk. In addition to real rates increasing, inflation can also be the cause of rate increases. In inflationary times like this, a strategic hedge could be buying TIPS (Treasury Inflation-Protected Securities). TIPS are a great hedge, as the both the principal and interest payments of TIPS increases with inflation. This kind of hedge is unique, as it uses the dangers of inflationary rate increases to an investor’s advantage.

Realistically, interest rate changes are inevitable in a healthy economy. Rate fluctuations seem to have a bad stigma, but if you understand these hedging techniques, it’s nothing to be afraid of. If investors can master these hedging strategies, as well as learn when to use them, investors can make interest rate fluctuations work in their favor.

[1] William Baldwin, “Seven Ways to Hedge Interest Rates”, Forbes, September 21, 2019, https://www.forbes.com/sites/baldwin/2019/09/21/seven-ways-to-hedge-interest-rates/?sh=935d5816f470 [2] Ben Lewis, “Tools to Manage Interest Rate Risk”, Chatham Financial, https://www.chathamfinancial.com/insights/video-tools-to-manage-interest-rate-risk [3] Justin Kuepper, “How to Mitigate Interest Rate Risk”, The Balance, June 30, 2021, https://www.thebalance.com/how-to-mitigate-interest-rate-risks-1978851 [4] Emily Norris, “Managing Interest Rate Risk”, Investopedia, July 18, 2021, https://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp