First things first, what is a structural hedge?
Just as you might want to lock in a fixed price for your future electricity bills so you don’t get shocked by higher rates, banks do something similar with their money. They want to avoid any nasty surprises when it comes to interest rate swings.
The easiest way to picture the hedge is like a bond portfolio. Banks use some of their assets to create a portfolio of bonds and earn a stream of cash flows at a fixed interest rate. In practice, this portfolio is largely made up of complex financial instruments, called swaps, but let’s not get bogged down in the financial jargon for now.
As rates in the real world go up and down, the hedge helps limit the impact of rate volatility and smooths earnings.
Why is structural hedging important now?
One of the ways banks make money is the difference between the rates they pay on deposits and what they charge on loans. When interest rates are high, they make more money, but when they’re lower, they make less.
So where does the hedge come in?
In tougher times, when rates are falling, the hedge can help create a buffer against the rate move. But it’s not quite as helpful when rates rise.
Think back to a bond portfolio, if you’ve locked in 1% and rates rise to 5%, your portfolio is going to lose some paper value (as rates rise, bond prices fall) and you’re missing out on higher rates.
That’s exactly what we’re seeing in the UK’s major banks, and right now the hedge is limiting the benefits from higher rates.
The tides are turning
The good news for banks is that the low rates on hedge business written over the past few years aren’t locked in forever. The rapid rate rises we’ve seen this year means as old contracts mature, the balance is reinvested at much higher rates.
It’ll take several years for the entire hedge to move onto new contracts, so there’s no guarantee it will all reprice at current levels. But on the basis that rates don’t fall back to ultra-low levels, there’s a multi-year tailwind on the horizon.
This isn’t a small fish either, major UK banks are expecting to earn billions more in interest income over the coming years.
Gross hedge income (£ billions)
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Source: Bloomberg, 2025 estimates from RBC Capital Markets (accessed 23.10.23).
The takeaway for investors
The hedge is key for banking risk management and is expected to provide a significant tailwind to earnings over the next few years.
Banks face other challenges, not least from the potential for higher loan defaults and a trickier mortgage market. The sector’s been underperforming for some time.
Total return
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Source: Refinitiv Eikon 31/10/23 (UK banks represented by the Refinitiv UK Banks Index).
We think this unloved sector is worth a look. At depressed valuations, the yields on offer (factoring in both dividends and buybacks) are attractive. We also think UK banks are also in a much better place to weather potential storms than they have been in the past. Of course, there are no guarantees and past performance shouldn’t be seen as a guide to the future.
This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Investments and any income they give you can fall as well as rise in value, so you could get back less than you invest.
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