2023 is kicking off with continued market volatility seen in the previous 12 months. In a Q&A, Jackie Bowie, managing partner and board member – head of EMEA and specializing in risk management for Commercial Real Estate at Chatham Financial, explores the top market challenges likely to shape 2023 and how firms can establish robust strategies to better mitigate and manage the impact on both interest rate and FX risk.
Q: Market challenges in 2023 – As it relates to interest rates and FX, what are the main market trends you see impacting the financial services sector in the coming year and why are these most significant to market participants?
A: Interest rates moved a lot in 2022. There has been a huge amount of volatility in the market, which hasn’t ended yet. There is an expectation that interest rates still have a way to go—although the forward curve across the main markets have priced some of that in. If you are looking at ae fixed rate product (swap) or any kind of derivatives, the price that you pay today already reflects the expectation that rates are going to move up further coming into 2023.
In fact, borrowers are now starting to wonder if rates have moved so far that they might turn, coming back down in 2023. The economic dynamic is shifting from an inflationary environment where central banks have to increase interest rates, to early signs of recession, where interest rates might have to be cut.
The speed at which everything changed in 2022 was a surprise to many borrowers. It feels like in 2023 we are not through the bad market news yet. There is still a lot of negative sentiment, and the higher interest rate environment has not yet been fully reflected in asset valuations. We will start to see that come through in valuations in the first half of 2023. Once valuations resets have occurred and if messaging from central banks shifts more doveish, the second half of 2023 might be more positive for transactions and investor sentiment.
Q: What are the challenges these market changes or trends present to financial market participants? Do these pose a particular challenge to both risk management practices and/or hedging strategies?
A: We’ve been in this very low, very benign interest rate environment for over 10 years. It made market participants quite sanguine about interest rate risk. The cost of debt was so low and interest rate risk has been almost non-existent. Going into 2023 firms are looking at a completely different cost of capital. It’s up over 300basis points in a year. That movement in the cost of debt changes how businesses run, how businesses fund themselves, what private market transactions will look like and how they are structured and paid for. That is quite transformational.
There are many participants who have been in financial markets for a long time but have not worked through a cycle like this before, with such a big increase in the cost of debt and the subsequent valuation reset.
In the last three to five years, the lending market has transformed. Prior to the global financial crisis, banks were the key lenders; lending into businesses, corporates, private equity, et cetera. They completely re-set their balance sheets post the GFC, as the global regulators required them to do, and their cost of capital increased. So, their balance sheets are in a much healthier state today than they were going into the last downturn What has filled the lending gap are alternative debt funds, so alternative credit, private debt, and they’ve been lending a lot in the last few years. The interest rate environment shift may change how they structure and make returns from lending.
Many borrowers will require covenant renegotiation. They might already be in breach of covenants, either in debt servicing, maybe loan to value (LTV). We will start to see those covenants coming under more pressure in 2023. Borrowers will go to their lenders to renegotiate their terms. The cost and structure of debt will be very different to what we’ve seen in the last 10 years as will the level of covenants that businesses and borrowers will have to adhere to.
Q: Do the market changes and challenges outlined deliver any opportunities to market participants?
It depends on the sector and asset class. If you were a privately owned business or private equity-backed business that was looking for an exit in 2022, one route for that exit is via IPO. The equity markets were largely closed to new issues in 2022, so those exits haven’t happened. There will be many businesses that will be looking for a new home. Corporates looking to make a strategic acquisition that have the capital to pay for it will find opportunities there and they might be cheaper than last year. It really depends on whether the acquiring business has the capital to support an acquisition.
If transactions rely on leverage to complete, there will be a different assumption of the cost of that leverage. A year ago, a real estate borrower for example might have assumed an underlying rate of 1.50% and a margin of 1.50%. Now, they will assume an underlying rate of 4.50% and a margin north of 2.00%.
Q: How can firms address the above challenges strategically? How might derivatives (interest rate swaps in particular) play a role in addressing these challenges or likewise supporting identified opportunities?
A: We could see lenders being more prescriptive about the hedging that businesses need to undertake as part of their own credit risk assessments. In the last 10 years, many lenders provided debt to businesses and might have requested hedging, but did not dictate the specifics of how that risk needed to be managed. We may start to see lenders making hedging a condition precedent of the loan with much tighter criteria of what that needs to look like.
That tends to just be on the interest rate side. You don’t tend to see lenders forcing hedging on the foreign exchange exposures. However, shareholders in businesses, whether they’re public or private, will be much more aware of the exposure that a business has to FX, and really start to question management teams as to their strategy to mitigate it.
There may also be an opportunity for the banks to be more innovative in terms of structuring different hedging products and coming up with new ideas to hedge risk. We have seen this in both the interest rate market and the FX market recently. This is where financial institutions are presenting products to their customers that look better value than what the market is pricing. For example, a vanilla fixed rate swap in the GBP market might be 4%. Bank A offers a derivative product, where the borrowers only need to pay 3.5% because of the structure of the product. However, borrowers should tread carefully because there is often something else hidden inside, such as an option or some kind of event trigger. There is no free lunch in the derivatives market.
Q: What advice would you give a potential client for one thing their organisation should do in the coming year?
A: Be prepared, not reactive. Many clients that are hedged are already looking out into 2024 and 2025 for opportunities to use their existing hedging and maybe stretch out another year. Be aware of products that are not quite what they seem. Have a very well-defined policy and strategy with clear parameters on what exposures you are willing to accept, because sometimes you don’t need to hedge everything, but that should be an active, informed decision. Have a pre-agreed policy and strategy that is just executed as part of a risk management program and be wary of structured products that look too good to be true.
