Back in the early 80s, the US Federal Reserve board - led by Paul Volcker – famously raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. These higher interest costs led to higher debt service costs, resulting in corporate failure and a recession in which national unemployment in the US rose to over 10%. The old adage “When America sneezes, the world catches a cold,” was never more prescient as the UK’s unemployment rate went even higher and the country’s inner cities burned.

There are differing views on the causes of inflation this time around. Clearly energy prices, thanks to the Russia-Ukraine war, are playing a big part, while the impact of Covid on global supply chains cannot be underestimated.

It’s worth noting that, historically, governments have used inflation to reduce debt-to-GDP ratios, particularly following a period of excessive government spending such as during wartime. This strategy is actually a stealth tax on a population as inflation exceeds pay rises and living standards inevitably fall. Nevertheless, it can resolve a sovereign debt problem as it erodes the debt to GDP ratio through inflating away the problem, rather than austerity and paying down debt.

In terms of the response to inflation, however, raising interest rates still appears to be the only solution in town.

So, what does this mean for UK SMEs? A company can reduce its level of debt (deleverage) through periods of inflation if its performance holds up and if it trades well. Furthermore, as the overall value of the business grows, its ‘debt to business value’ ratio will naturally fall. Nevertheless, with interest rates now rising after a long period of historically low rates, any business that has debt at a floating rate is undoubtedly at risk.

One particular safeguard for SMEs is the use of a ‘hedging’ product. Put simply, a hedging product enables a SME to protect itself against adverse movements in interest rates. Typical hedging instruments include interest rate swaps, interest rate caps and interest rate collars. Such instruments can be used to fix an interest rate, put in place a cap (ie a worst case interest rate), or define an interest rate collar that provides protection within a set interest rate range. This enables an SME to better plan its operations and protect itself against rising interest rates.

Unfortunately, the hedging options available to SMEs have vastly diminished and we do not need to look back too far to understand why. Historically, large corporates managed interest risk by exchanging interest rate flows, passing fixed and floating rates between themselves dependent upon what their position required. The banks became intermediaries in this market which was to come under the banner of ‘Derivatives’.

Derivatives are complex hedging instruments. They were the domain of large corporates, financial institutions, central banks, hedge funds and sophisticated counterparties. In 2002 Warren Buffett famously described them as “financial weapons of mass destruction”.

Around the turn of the century the high street banks that already played a part in such markets with larger intermediaries, such as RBS / NatWest, Lloyds, Barclays, and HSBC, started to sell interest rate derivatives (or ‘swaps’) to their vast network of owner-managed SME clients. These were sold at much wider spreads than in the inter-bank market and were not only popular with SMEs, but also hugely lucrative for the banks.

The noughties were a period of ‘super normal’ profits for the banks and derivative income was a big part of this. However, following the financial crisis of 2008, the Bank of England cut the UK base interest rate to 0.5%. For a decade the banks had been selling hedging products at the long run average of circa 5%. Consequently, these products were now hugely problematic for SMEs, with large mark-to-market positions, leaving clients paying a much greater interest rate than the new prevailing market rate. The opposite of what we are seeing today as base rates rise leaving many exposed to variable interest rates.

Naturally, UK SMEs were soon in uproar. Government and regulatory intervention followed with banks having to unwind these hedging products and compensate their customers. Fortunately, retail clients did receive full redress against these products and were afforded greater protection than ‘professional’ (larger, more sophisticated) clients, who were not compensated.

The result of all this, and why it affects SMEs today, is that banks are now generally averse to re-entering the hedging market for SMEs. It is difficult to access the market if you are not a professional corporate client or borrowing over £10m. This leaves a limited range of products or counterparties for the SME as they look to mitigate their interest-rate risks. Nevertheless, traditional hedging instruments such as interest rate swaps, interest rate caps and collars are available, and banks typically offer fixed rate solutions.

The alternative lending market, which is now worth over £6bn, is also a potential saviour for SMEs. Although fixed-rate product ranges are still relatively uncommon, we are seeing options beginning to emerge.

If you are interested in the hedging options currently available to SMEs, please get in touch.

Alexei Garan is Partner - Business Funding, at corporate finance experts Shaw & Co.

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