Using Corporate Inflation Protected Securities to Hedge Interest Rate Risk

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In the first half of 2008, rising inflation became a concern, but by the fall the focus was on deflation. Such shifts in the outlook for inflation represent a significant risk for some companies, particularly those whose revenues and profits are negatively affected by increases in inflation and rates. For such companies, the use of long-term fixed-rate debt will provide at least a partial hedge against increased rates.

Less widely appreciated is that even companies whose profits move up and down with inflation face considerable risk from fluctuations in interest rates. Conventional wisdom holds that floating-rate debt hedges this risk. But this article argues that floating-rate debt still leaves a company exposed to increases in real interest rates.

Inflation-sensitive companies such as utilities can use corporate inflation-protected securities (CIPS) to hedge their real interest rate risk as well as inflation risk. In addition to its hedging benefits, CIPS also have the potential to reduce borrowing costs by satisfying growing investor demand for high-quality securities that provide inflation protection (including demand sources like the recent restoration of French savings accounts to inflation).