What should my board know about interest rate hedging?

Hedging arrangements are commonplace among housing associations and are a useful tool for mitigating financial risk.   In times gone by, lenders were willing to offer long-term fixed or hedged rates of interest under the loan facility agreement.  In the current market, whether due to changes to the loan structure, increased internal accounting scrutiny and/or market-wide changes to benchmarks, lenders are now reluctant or even, in some cases, unable to offer embedded hedging options.  Therefore, many borrowers now enter into separate stand-alone hedging agreements with bank counterparties in order to mitigate their exposure to fluctuations in interest rates.  Stand-alone agreements have the advantage of greater control for borrowers to manage their arrangements, but they are complex and require an additional level of legal and treasury competency to ensure the terms are appropriate. 

Whenever you are contemplating entry into hedging arrangements, you must: 

1. Check that your constitutive documents allow it. 

Ensure you review your constitutional documents, and the powers that are set out within them, to confirm whether you have the power to enter into the proposed arrangements. 

For example, the National Housing Federation model rules expressly grant the power to enter into and perform any derivative transaction seen fit for the purpose of hedging or otherwise managing any treasury risk or other financial exposure, but not all associations use the NHF model format. 

2. Even if your constitution permits derivative transactions, your actions must be consistent with your charitable objects and the Regulatory Framework. 

While the Regulatory Framework anticipates and does not prohibit entry into derivative contracts, you must always have regard to the overarching requirements of good governance pertaining to prudent financial management, maintaining liquidity, managing financial risk and, ultimately and always, protecting social housing stock. 

If you are a charity, any powers must be used to further your charitable objects.

3. Obtain specialist treasury advice. 

The Regulator of Social Housing expects registered providers to engage independent, specialist external advice as appropriate, and Charity Commission guidance specifically recommends that charitable landlords obtain appropriate external advice in relation to derivative transactions.  In conjunction with this, it is crucial that Boards have the skills and expertise to understand and effectively challenge any financial advice obtained, especially when considering innovative and / or complex funding structures.  We are able to conduct board training sessions tailored to your organisation's needs on request.

4. Ensure that your own board fully understands the proposed arrangements and any legal and treasury advice presented to them. 

The Regulator expects registered providers to ensure that they properly understand any capital markets and financial products they are exposed to.  It also expects to see evidence that a critical assessment has been undertaken by the board.  The recently published Select Committee report on the finances and sustainability of the social housing sector encouraged the Regulator to undertake rigorous improvements in their own understanding of complex and innovative financial models and tools, and it recommended that the Regulator, as part of its governance ratings, examine whether boards have sufficient expertise in the financial models they are using.  This reiterates the guidance in the Regulator’s own Sector Risk Profile of November 2023.   

5. Enter a Master Agreement in the form published by the International Swaps and Derivatives Association (ISDA)

The ISDA Master Agreement creates a framework to cover all hedging transactions with a single bank counterparty.  The Master Agreement takes a standard format without scope for negotiation, although certain terms can be tailored to the parties’ requirements in a schedule.  Credit support is similarly documented through non-amendable annex with a final paragraph that can be tailored for specified terms.  The commercial terms of each swap transaction are set out separately in a “Confirmation” - this is a short document that (again) uses standard definitions and terms, incorporated by reference. 

The documents, definitions and other terms are only available from ISDA.   They are largely standard, but they are also complex.  Standard ISDA terms may not correspond to the terms of the underlying facility agreement.  It is advisable to seek out legal advice to ensure you understand and help you to document the arrangements you require. 

If you require legal advice or training in relation to proposed hedging arrangements and the associated regulatory, governance and charity law implications, please get in touch with any of your usual contacts at Devonshires.