Some risks — like the risk of a rainout when you schedule a round of golf two weeks ahead — are impossible to eliminate. Risks associated with business borrowing costs, in contrast, can be hedged efficiently, and growing numbers of middle-market companies are doing so.
While bond market analysts aren’t anticipating a spike in interest rates, even a modest increase could put a squeeze on business borrowers, particularly those in cyclical industries and those operating on thin margins.
With the Federal Reserve seeking economic justification to begin ratcheting rates back to more traditional levels, companies accustomed to low borrowing costs cannot take today’s favorable environment for granted.
Basic Hedging Tools
Interest rate hedging techniques include caps, collars and swaps.
With a cap, the lender agrees, for a fixed period of time, to a ceiling on the interest rate on a borrower’s variable rate loan in exchange for an up-front fee.
A collar arrangement involves hedging both an upper limit with a cap and lower limit with a floor on the variable loan. While the borrower is protected when the variable rate exceeds the cap, the borrower gives up the potential to come out ahead if rates drop below the floor rate.
With a swap, the borrower continues to pay the bank whatever is due based on the variable rate loan as before; the original loan contract remains intact. The borrower then enters into a separate agreement with the bank’s Derivatives Group to effectively lock in its interest rate.
On each payment date, if the interest rate the borrower pays on the loan is less than the agreed upon fixed rate, the borrower makes an additional payment to the Derivatives Group to bring the effective interest cost up to the agreed upon rate.
If the interest rate the borrower pays on the loan is more than the agreed upon fixed rate, the customer makes the higher interest payment on the loan and the Derivatives Group reimburses the customer for the amount to bring the effective interest cost down to the agreed upon rate.
To be eligible for any derivative product, Dodd-Frank regulations require companies to have at least $10 million in assets or a net worth of at least $1 million. A swap generally is economically viable for a loan whose value times the average life of the swap is at least $6 million. Thus a $1 million loan with a six year swap contract would meet the test.
One of the main benefits of derivative products is their flexibility. The duration of swap contracts does not need to coincide with the underlying loan’s term. For example, a borrower with a 10-year variable rate loan term might decide only to hedge the first five years of the loan, leaving open the opportunity to negotiate a new swap agreement in five years. The borrower’s motivation for doing so would stem from the general pattern that the longer the swap, the higher its cost.
It may also be possible to arrange a swap that doesn’t kick in until some date in the future.
Swap contracts can be terminated by the borrower prematurely. If interest rates for the remaining term are lower than the contract rate at the time of the termination, the borrower will be required to pay a fee that will make the bank “whole” to the contract rate. But if the contract rate is higher, the borrower will receive a fee from the bank that will make the borrower “whole” to the contract rate.
Some companies structure cancel options into the interest rate swap contract to provide for unforeseen events such as asset sales, unexpected cash flows or business changes.
To learn more about managing interest rate risk, contact us. Our Derivatives Specialists can help you understand derivatives products and evaluate an appropriate hedging strategy designed to protect your business’s bottom line.