Interest rate hedging is most commonly used in conjunction with variable rate debt to help borrowers protect – or hedge – against rising interest rates. Borrowers have a myriad of alternatives when exploring interest rate hedging solutions: caps, collars, swaps, cancelable swaps, forward swaps, swaptions.
Below are brief summaries of a few common interest rate hedging techniques, but keep in mind that there are additional strategies that borrowers can use to hedge their interest rate risk. To talk about these strategies as well as others that may achieve your objectives, contact us today.
An interest rate cap is designed to prevent variable interest rates from exceeding a maximum limit, or cap strike. The cost of a cap is determined by a number of factors including cap strike, maturity, notional, amortization, day-count convention, index, payment periodicity and volatility and is typically purchased upfront for a fee.
In our example below, the borrower desires to hedge its variable rate loan priced at 1 Month LIBOR + Spread. The cap seller will make payments to the borrower any time LIBOR exceeds the strike rate. In this way, the rate on the borrower’s loan will never exceed the cap strike during the term of the cap*.
An interest rate collar is a combination of a cap and a floor and is designed to limit variable interest rates to a range. A collar can be structured so that there is little or no upfront cost.
In our example below, the borrower desires to hedge its variable rate loan priced at 1 Month LIBOR + Spread. The collar provider will make payments to the borrower any time LIBOR exceeds the cap strike, while the borrower will make payments to the collar provider any time LIBOR is below the floor strike. In this way, the effective rate on the borrower’s loan will never exceed the cap strike nor fall below the floor strike during the term of the collar*. The borrower’s net payments on the loan and the collar remain in a predetermined range regardless of what interest rates do, providing predictability on a variable rate loan for the term of the collar.
A variable-to-fixed interest rate swap is an exchange of payments designed to fix the interest cost on a variable rate loan. The swap can be structured with no upfront cost and can even be structured to pay a premium to the borrower at inception.
In our example below, the borrower desires to hedge its variable rate loan priced at 1 Month LIBOR + Spread. The swap provider will make payments to the borrower based on LIBOR + Spread that the borrower will then pay on its loan. In return, the borrower will pay a fixed rate of interest to the swap provider. The combination of a variable rate loan plus a variable-to-fixed swap effectively gives the borrower fixed rate debt for the term of the swap*.
Borrowers can embed par cancellation features into their swaps to either 1) add flexibility or 2) obtain lower fixed rates. If a borrower wants to add flexibility, it can structure the ability to cancel the swap – at par – on or after a specified date. By doing this, the fixed swap rate will increase, but the borrower will not be exposed to any swap termination fees on the call date(s).
If a borrower wants to obtain a lower fixed swap rate, it can give the swap provider the right to cancel the swap – at par – on or after a specified date. By doing this, the fixed swap rate will decrease, but the swap provider may cancel the swap, leaving the borrower exposed to rising interest rates.
Combining interest rate hedges with variable rate debt provides a lot of benefits to borrowers. However, these products are very complex to model, price and value. Commercial Defeasance brings the requisite knowledge and experience to help you confidently navigate this market. As an interest rate hedging advisor, Commercial Defeasance provides:
Structuring and Idea Generation
We constantly monitor our clients’ hedging portfolios for ways to add value. This could include shortening or lengthening the duration, adding call features, executing partial terminations or layering basis swaps onto existing hedges. Need prepayment flexibility? Need to hedge 10-year Treasury rates, 1-Month LIBOR, SIFMA, PRIME, CPI? We will ensure that any type of hedge you consider helps achieve your objectives at fair terms and transparent pricing.
Commercial Defeasance’s fee can be structured into most interest rate hedges so that you don’t pay cash out of pocket. In most cases, our fee more than pays for itself from the money saved on hedging transactions. So in addition to overall savings, borrowers get professional advice on structuring, documentation and valuation of interest rate hedges.
Why should banks hold all the cards? Commercial Defeasance uses live market data and market tested models to provide our clients with real-time pricing on customized interest rate hedging solutions. The key to negotiating fair terms and pricing is knowing where the market is.
We will negotiate all the appropriate documentation including, but not limited to: authorizing resolution, hedge designation letter, ISDA Schedule to the Master Agreement, Credit Support Annex and confirmation.
Whether your lender requires a hedge as a loan condition or you want to explore alternative hedging solutions on your own initiative, we will ensure that you fully understand the mechanics, benefits and risks of these products in order to make an informed, strategic decision based on your future plans and goals.
You probably have some questions - and we've got the answers.
Check out our FAQ page to learn more ›
Why can’t we (the Borrower) just use our Lender to hedge? What value do you provide?
What type of situations/clients best suit your services?
What products/services do you offer that would be useful for commercial real estate owners?
How is your fee collected?
In most cases, the borrower will use its lender to hedge. We ensure that when borrowers hedge with their lenders 1) they implement hedging strategies that are custom tailored to their needs, 2) they fully understand the mechanics, benefits, and risks of the strategy, 3) they get fair pricing and terms, stronger covenants, and transparency. We can also help explore hedging with providers other than a borrower’s direct lender.
Most commonly, variable rate borrowers are the primary end user for interest rate hedges. This typically includes single asset real estate borrowers, REITs, corporations, non-profits, and municipalities. This can include hedging a new term debt facility, or bidding out a swap termination in conjunction with a refinance or sale of an asset.
We advise numerous real estate owners on the development and implementation of interest rate hedging solutions. This may include an interest rate swap, cancellable swap, interest rate cap, or interest rate collar. Our goal is to structure hedges that achieve borrowers’ objectives and getting those hedges implemented at aggressive levels. We also assist these borrowers in terminating interest rate hedges at aggressive levels.
In most cases we can structure our fee within a hedging transaction so our clients do not have to pay out of pocket today. For some products, such as interest rate caps, we charge an up-front fee to auction the product to several dealers.