A common interest rate hedging strategy is converting LIBOR-indexed variable rate debt to fixed rate debt using an interest rate swap, or protecting interest expense through entering into a costless collar or purchasing an interest rate cap. If cash flow hedge accounting of benchmark interest rate risk (LIBOR) is elected, consideration should be given to the index driving the variable rate debt vs. the contractual variable index in the hedging derivative. Ideally, the tenor of the variable rate index in the debt (e.g. 3M LIBOR) matches that of the derivative, as well as the dates on which the variable rate index change (e.g. both debt and derivative reset at calendar quarter ends). Reset date differences on the debt and the hedging derivative will typically cause only minor hedge ineffectiveness, if the LIBOR tenors of hedged debt and derivative are the same. Tenor differences on the debt’s and derivative’s variable rate indices will typically cause more hedge ineffectiveness (e.g. if 1M LIBOR or 6M LIBOR debt is hedged with a 3M LIBOR swap).
In addition, interest rate hedgers should consider whether their variable-rate borrowing arrangements allow for flexibility in the choice of the LIBOR tenor (1, 3, 6 month), and whether or not they would like to utilize those options and change the tenor of the index once the debt has been hedged. Typically, preserving that flexibility on the hedged debt involves increased administration in terms of hedge effectiveness assessment and documentation. In addition, whenever possible, hedging relationships should be designated as of the trade date of the derivative, as designations subsequent to that date may produce additional hedge ineffectiveness, due to the derivative’s value being off-market at the point of designation.
