Limited Derivatives Users—Applying the Interest Rate Hedging Exclusion

By Stephen A. Keen and Andrew P. Cross

Our last post examined examples of currency hedges that we believe Rule 18f‑4(c)(4)(i)(B) should allow a fund seeking to comply with the Limited Derivatives User requirements to exclude from its derivatives exposure. This post struggles with examples of interest-rate hedges that may, or may not, be excluded.

A Paradigmatic Bond Hedge

As originally proposed, Rule 18f-4 would have excluded only currency hedges. The final rule added the exclusion of interest-rate hedges based on commenters who:

routinely enter into fixed-to-floating interest rate swaps (or vice versa) and [match] these transactions … to the notional amount and maturity of a specific security in the fund’s portfolio.”

As the SEC added the exclusion of interest-rate hedges to accommodate these commenters, it is reasonable to conclude that such a fixed-to-floating rate swap could be excluded from a fund’s derivatives exposure. We are less sure about the “vice versa,” as a floating-to-fixed rate swap would increase, rather than mitigate, a fund’s interest-rate risk. We do not believe the SEC would view using derivatives to increase duration as a “hedging purpose.”

Continue to the full post at Asset Management ADVocate.