In our conversations over the years with borrowers of all shapes and sizes, in a myriad of industries, we’ve seen time and time again that all borrowers share the same basic goal: to take advantage of low interest rates now while protecting themselves if interest rates rise in the future.
Some borrowers opt for the easy method of avoiding interest rate risk: borrow at a variable rate indexed to 1M LIBOR and then fix the rate on the entire loan for the full term with an interest rate swap. A strategy also known as “Fix it and Forget it.” Sometimes doing so makes the most sense given the borrower’s plans for the underlying asset, or a view on the future direction of interest rates. Other times, it makes more sense to hedge a portion of the debt, fix the rate for less than the full term or not hedge at all. Each borrower’s situation is unique.
Viewing a borrower’s best method of hedging interest rate risk is often murky. Much of this opacity hinges on what interest rates are expected to do in the future. Under most circumstances, the markets are fairly accurate at forecasting the direction of interest rates for the next 18 months. Beyond that, staring into the proverbial crystal ball is like staring into a billiard ball. As such, predicting long-term rates is often more art than science. Ask a few economists what they expect the 10-year Treasury note to yield at the end of 2020. You will quickly realize no one really knows.
The Fear Premium
For the past decade or so, the only attractive methods of hedging interest rate risk were limited to swaps, forward starting swaps, rate caps, step-up rate caps, and corridors. Instead of using the very common method of using a swap to hedge, it’s often better to hedge rate risk by buying a short-term rate cap, with the expectation of extending the rate cap for an extra year or two prior to loan maturity. Why not buy a single rate cap for the entire loan term? The interest rate uncertainty implied by financial markets forces banks to overcharge for hedges, and they’re justified to do so by the great economic and geopolitical uncertainties that exist at present. We call this the “Fear Premium.”
To explain, let’s take a look at a $20mil, 5-year loan, that requires the purchase of a rate cap with a 3.00% strike on 1-month LIBOR:
- Hedging with a 2-year rate cap would cost: $16,000
- Hedging with a 3-year rate cap would cost: $50,000
The 3-year rate cap is over THREE TIMES the cost of the 2-year, even when markets don’t expect 1-month LIBOR to get anywhere near the 3.00% rate cap strike in the next three years. This implies that financial markets aren’t worried about LIBOR exceeding 3.00%, but are more worried about it breaching 5.00% or higher.
So why is the 3-year rate cap so much more expensive? The Fear Premium: banks selling rate caps seek to protect themselves from an unexpected spike in LIBOR two plus years from now, and therefore build in a big buffer in the price to protect themselves.
Rate cap prices are driven mainly by two factors, 1) rate expectations (swap rates), and 2) volatility (uncertainty) of rates. With the 3-year swap rate at just over 2.45%, it isn’t the main driver of the ridiculous 3-year cap cost, thus it must be uncertainty.
So what’s a floating rate borrower to do?
- Consider Swaps to hedge floating rate risk: nearly everyone understands swaps. They’re attractive now because of flat yield curves and the resultant lower fixed rate they offer over historical levels. These same factors also lower the downside risk to the borrower if they terminate the swap prior to maturity. Looking back at our 5-year loan example above, the 5-year swap rate – the fixed rate the borrower would end up with by fixing their floating rate with a swap – is 2.47%, that’s lower than where 1-month LIBOR is today – 2.49%. Not bad at all.
- Better yet, consider an Interest Rate Collar: the mechanics are the same as a swap, but the difference is that the hedger establishes a defined RANGE (floor and ceiling) of interest rates they’ll be subjected to as opposed to a single, fixed interest rate as in a swap. Said another way, with a collar, the hedger is certain that they’ll be exposed to LIBOR within the defined range – and in so doing can enjoy a lower potential rate than what the swap provides. Further, the collar can be structured with no up-front cost to the borrower unlike an interest rate cap which requires the hedger to pay its cost up front.
Interest Rate Collars are looking very good right now, but their appeal waxes and wanes with rate movements and economic events and may be short-lived. Should yield curves dramatically steepen, the belief in a “patient” Fed evaporate, or a recession occur, the collar will quickly lose its appeal.
How does a collar work?
First off, interest rate collars didn’t make sense for nearly a decade after the financial crises. The current low rate environment and flat yield curve have changed that. Here’s an example of how they work:
- Notional: $20mm Interest Only
- Start Date: 3-1-19
- Term: 5 Years
- Index: 1M LIBOR
- LIBOR Cap: 3.00% (red line on chart)
- LIBOR Floor: 1.80% (red line on chart)
- Current 5-year Swap rate is 2.47% (green line on chart)
Opportunity: LIBOR trades between 1.80% and 3.00% over the next five years
- You are subject to the LIBOR spot rate within the 1.80% to 3.00% range
Protection: LIBOR trades above 3.00%, aka the “ceiling”
- Your exposure to LIBOR is capped at 3.00%
Risk: LIBOR trades below 1.80%, aka the “floor”
- Should LIBOR trade below 1.80%, you are obligated to pay the difference between LIBOR of 1.80% and where LIBOR is below that level (which could even be below 0%)
- No out-of pocket cost to hedge (“zero cost”)
- Full protection against LIBOR above 3.00%
- Ability to enjoy a LIBOR rate below the current 5-year, 2.47% swap rate if it comes to pass
- LIBOR’s defined range between 1.80% and 3.00%, via the Collar, creates certainty in that you know you’re exposed to LIBOR within the range and never outside of it
- You will be obligated to make a payment if LIBOR falls below the 1.80% floor
- There is the potential opportunity cost if LIBOR trades and stays well above the current 5-year, 2.47% swap rate. However, just because LIBOR exceeded the swap rate doesn’t necessarily result in an opportunity cost. Keep in mind, the swap rate is what the market expects LIBOR to average over 5 years. Opportunity cost comes into play if LIBOR averages more than the 2.47% swap rate over the 5-year life of the collar.
Collar vs. Swap
As stated before, a collar establishes a defined RANGE (floor and ceiling) of interest rates the hedger is subjected to as opposed to a single, fixed swap rate.
Imagine buying a 2.47% LIBOR cap and selling a 2.47% floor. What have you got? A 2.47% swap. Again, a collar is simply a swap with a range (the Cap and a Floor), customized by the hedger to meet their unique goals and objectives.
When considering a swap, it’s important to remember the hedger’s potential opportunity cost: if rates stay below the hedged swap rate (2.47% in the graph below). When considering a collar, one should consider the possibility of LIBOR rising above the swap rate and staying there over the life of the hedge (also 2.47% in the graph below).
Final Thoughts on Collars
Any bank on the other side of an interest rate swap or collar will charge a spread for the risk it deems it’s taking on in doing so. However, from the bank’s perspective, it’s risk on a collar is lower than for a swap, therefore it’s spread on a collar will be less than for a swap. That’s good for the borrower. Additionally, should the borrower pay off the loan early and choose to terminate the collar before maturity, it’s risk of paying out of pocket to terminate is lower than if they’d hedged with a swap.
Questions? Curious what a collar can do for your particular exposure? Call us: 415-510-2100.