Interest rate risk

What it means

Interest rate risk is the risk that changes in interest rates will adversely affect a company's results or value. For borrowers it means above all that rising rates increase the cost of floating-rate loans. For lenders and investors it means lower deposit income when rates fall, or a fall in the value of fixed-income bonds when rates rise.

Business loans in the euro area often carry a floating rate made up of a reference rate, mainly EURIBOR, plus the bank's margin. The margin is fixed while EURIBOR moves with the European Central Bank's monetary policy. The experience of 2022 and 2023, when rates rose sharply in a short time, showed how quickly higher interest can strain cash flow.

Interest rate risk also affects floating-rate leases, overdrafts, factoring and revolving credit. Even companies without loans feel it indirectly, through customer demand financed by credit, property prices or company valuations that depend on the discount rate.

How it works in practice

The first step is an overview: which loans the company has, what rates apply and when they reset, and how much costs would rise if rates went up by one or two percentage points. Such a sensitivity analysis shows whether the risk is material. It is also important to watch interest cover, how many times operating profit covers interest.

The simplest protection is fixing the rate for a period directly in the loan agreement. For larger loans, derivatives are used, mainly an interest rate swap that converts a floating rate to a fixed one, or an interest rate cap that limits the maximum rate. The choice depends on the expected path of rates, the cost of hedging and the company's risk tolerance.

For larger loans, banks sometimes require interest rate hedging and set covenants tied to leverage or interest cover. When rates rise, a company can breach covenants even though operations are going well. Interest rate risk should therefore be built into financial planning and stress scenarios.

What to watch out for

A common mistake is deciding on fixing based only on the current rate. A fixed rate brings certainty, but if rates later fall the company pays more than the market and early repayment may carry a fee. A floating rate is cheaper when rates fall but carries risk. Combining the two and staggering fixed periods is sensible.

Hedging derivatives must be understood and monitored. A swap taken out to protect a loan has its own value that moves with the market, and terminating it early can mean a significant payment. Before signing, have all terms explained, together with the consequences for accounting, hedge accounting and tax.