Hedging in an Uncertain Interest Rate Cycle – Interest Rate Collar

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Of the frequent publications we produce, this one is unique and worthy of your special attention as we dig into a few hedging alternatives that you may not be familiar with because they haven’t made sense for a very long time. If you have questions after reading please give us a call.

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 basically 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 by borrowing variable indexed to 1M LIBOR and then fixing the rate on the entire loan for the full term with an interest rate swap: “Fix it and Forget it”. Sometimes doing so makes the most sense given the borrowers plans for the underlying asset, or a view on the future direction of interest rates. Often times, it can make more sense to hedge a portion of the debt, fix the rate less than the term or not hedge at all. Each borrower’s situation is unique.

Surprisingly to some borrowers, swaps aren’t the only way to mitigate interest rate risk.  In the following, we’ll highlight interest rate collars as a recently viable method to mitigate risk, while participating in the current low rate environment.

A borrower’s best method of hedging interest rate risk is often muddy. Much of the opaqueness 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.  The crystal ball isn’t perfectly clear, but through the haze one can see through the crystal up to a point.  Beyond 2 years, let alone 3 or more years, the crystal ball is no clearer than trying to see what’s behind the 8 ball. Predicting long-term rates can be more art than science.  Ask any economist where they expect the 10 year Treasury note to yield at the end of 2017.  You will quickly realize no one really knows.

The Fear Premium

For the past decade or so, hedging structures were limited to swaps, forward starting swaps, caps, step-up caps, and corridors.  Routinely, we see situations where it makes the most sense for a borrower to buy a short-term cap, with the goal for extending the cap for a year or two prior to maturity. Why not buy a single cap for the entire loan term? The market is overcharging for the great uncertainties facing the global economy and markets at present. We call this the “Fear Premium”.

To explain, let’s look at a $50mil, 3-year loan, with a required cap strike of 2.00% on 1-month LIBOR:

  • Hedging with a 2-year cap would cost: $20,100
  • Hedging with a 3-year cap would cost: $110,500

The 3-year cap is FIVE TIMES the cost of the 2-year, even when markets don’t expect 1-month LIBOR to get anywhere near the 2.00% cap strike in the next three years.  Obviously, the market for caps isn’t worried about LIBOR exceeding 2.00%, but breaching 5.00%

So why is the 3-year cap so much more expensive? Fear premium.

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 just over 1%, it isn’t the main driver of the ridiculous 3-year cap cost, thus it must be uncertainty. Lets take a quick look at what could move rates in the future:

1) BREXIT: The UK referendum vote on June 26 on whether England remains part of the EU

  • What are the implications for Europe, England and the U.S.? No one really knows but they could be huge.
  • We expect an exit to vote will disrupt markets for the foreseeable future.

2) Negative interest rates.  Is there a possibility for negative rates to show up outside of the Europe and Japan or even in the U.S.?  Banks are worried enough to insert interest rate floors of 0% to 0.50% on variable rate debt.

3) The upcoming US Presidential election. Normally, markets don’t build in too much rate uncertainty with presidential elections.  However, this election cycle is an exception.

4) Negative swap rates: A topic we’ve covered extensively in our monthly newsletters and in our Derivatives 101 class (please let us know if you would like us to send our report or schedule a lunch and learn), and one that’s likely to persist, add increased volatility and uncertainty for the long term.

So what’s a floating rate borrower to do?

  • Consider Swaps to hedge floating rate risk: Nearly everyone understands swaps, they’re more attractive now because of the lower fixed rate they’re offering over historical levels and downside risk is lower if the swap is terminated prior to maturity.
  • 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 interest rate as in a swap. With a Collar, the hedger is certain that they’ll be exposed to LIBOR within the defined range. The collar can be structured with no up-front cost unlike an interest rate cap which requires the hedger to pay a premium upon purchase.

Interest Rate Collars are looking very good right now, but the opportunity to hedge with a collar may be short-lived.  The yield curve could steepen, negative yield fears could dissipate, or the economy could strengthen.  If any of these situations arises, the collar will likely lose some hedging appeal.

How does a collar work?

First off, Interest Rate Collars haven’t made sense for nearly a decade. The current low rate environment and flat yield curve have changed that. Here’s an example of how they work:

Assumptions

  • Notional: $10mm Interest Only
  • Start Date: 7-1-16
  • Term: 5 Years
  • Index: 1M LIBOR
  • LIBOR Cap: 2.00% (red line on chart)
  • LIBOR Floor: 0.50% (red line on chart)
  • Current 5 year Swap rate is 1.10% (green line on chart)

Collar June 2016

Possible Outcomes

Opportunity: LIBOR trades between 0.50% and 2.00% over the next five years

  • You are subject to the LIBOR spot rate within the 0.50% to 2.00% range

Protection: LIBOR trades above 2.00%, the “ceiling”

  • Your exposure to LIBOR is capped at 2.00%

Cost: LIBOR trades below 0.50%, the “floor”

  • Should LIBOR trade below 0.50%, you are obligated to pay the difference between LIBOR of 0.49% and actual LIBOR (which could be negative)

Potential Benefits

  • No out-of pocket cost to hedge (zero cost)
  • Full protection against LIBOR above 2.00%
  • Ability to enjoy a LIBOR rate below the current 5 year, 1.10% swap rate
  • Defined rate range creates certainty

Risks

  • You will be obligated to make a payment if LIBOR falls below the 0.50% floor
  • There is the potential opportunity cost if LIBOR trades above the current 5 year 1.10% 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 swap rate.

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 1.10% LIBOR cap and selling a 1.10% floor. What have you got? A 1.10% 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 (1.10% in the graph below). When considering a collar, one should consider the possibility of LIBOR rising above the swap rate the hedger could have hedged at (also 1.10% in the graph below).

Swap June 2016

Beware of market anomalies because they usually don’t end on a happy note.

Questions? Curious what a collar can do for your particular exposure? Call us: 415-510-2100.