How to Dissect a Fixed Rate

Not all Fixed Rates are the Same

We are often asked if a fixed rate quoted by a bank is competitive.  Seems like a simple question, but in practice, it’s a difficult one to answer without proper analysis.  Numerous factors determine how a lender arrives at a fixed rate.  In this month’s report, we will explain differences in how fixed rates are calculated and the subtle nuances in doing so that can make a big difference in making the right financing decision.

Let’s start with how we dissect a fixed rate quote a bank has offered to begin the process of competitive analysis.

Banks are Vulnerable to Interest Rate Risk

Casinos are very averse to risk (they don’t gamble), and despite some of the risks banks have taken (the credit crisis of 2008 and Dot-Com bubble come to mind), interest rate risk remains their core risk.  A bank’s main concern is protecting the credit spread they charge the borrower.  If the loan is indexed to 1-Month LIBOR plus a credit spread, the bank isn’t necessarily at risk if variable rates rise because the borrower assumes the rate risk.  Of course, if variable rates rise beyond the ability of the borrower to pay, the bank is subject to interest rate risk.  On highly levered loans, banks may require the borrower to hedge the variable rate risk with an interest rate cap or swap.

If the borrower wants a fixed rate loan, the bank will offer an interest rate swap (a very profitable product for a bank and should not be entered into without an independent consultant) to synthetically fix the rate by entering into a contract to pay the borrower the variable rate in exchange for a fixed rate.

What is a Community Bank?

Community banks serve the needs of small local businesses and focus more on relationships.  The bankers who make the credit decisions live in the community and know their customers.  Most small businesses often have to rely on a community bank because, even though the borrower might be considered low risk, larger banks have more structured underwriting requirements.  While a relationship with a larger bank is important, credit decisions are often made outside of the community.

Generally, community banks offer fixed rate term  loans with 5-year maturities and some can offer fixed rate terms up to 10 years.  Unlike large commercial banks, defining the community bank’s cost of funding, and hence the competitiveness of any fixed rate financing they offer, can be a challenge.

Deconstructing a Bank’s Fixed Rate

There are various benchmarks banks use to quote fixed rates.  Community banks will often use the Federal Home Loan Bank (FHLB) term rate and add their credit spread.  When quoting a 10-year loan, more often than not, community banks will quote a fixed rate for 5-years with a reset after year 5 that sets the fixed rate for the last 5 years of the loan.  If the quote is for 10-years without a 5-year reset, the spread over the index is generally higher.  In the event the loan is paid off early, community banks typically have an interesting way of calculating the cost to pre-pay the loan.  We call it a “5-4-3-2-1” program, meaning that if the borrower pays off the loan after 3 years, the cost to the borrower to do so is 3% of the outstanding loan balance.

Let’s assume the following:

$10MM loan balance

Funding Date: 12-1-18 (important to provide a best estimate)

Maturity Date: 12-1-28 (a 10-year loan term)

Amortization: 20 year mortgage-style

Bank fixed rate quote: 5.75%

No Free Lunch

Let’s apply these concepts to our loan assumptions: We recently reviewed a proposal with a 5-4-3-2-1, but the term was for 10 years and fixed.  This means the borrower could pay-off the loan with no pre-payment penalty after five years, but this leniency from the bank meant that the borrower paid a higher credit spread over the index in return.  Makes sense, because the risk to the bank is if interest rates go down and the borrower has an option to take advantage of lower rates.  What a borrower needs to consider is if the additional cost is worth the more lenient prepayment terms.  We can quantify the cost of this optionality to better compare terms with other credit providers ( we recommend hiring an independent advisor to provide the analysis).

Comparing Apples to Apples

Without going into the complexities of valuing the no pre-payment optionality, our first step when analyzing a fixed rate offer is to figure out what credit spread is added to a universal benchmark, like the swap rate.  The swap rate is based upon what the futures market expectations are for 3-Month LIBOR over a given period of time.  While the LIBOR futures market is based upon 3-Month LIBOR contracts, most banks index their variable rate loans to 1-Month LIBOR plus a credit spread.  For an apples to apples comparison, some interpolation needs to be priced into the swap rate, especially if the loan is amortizing.  This type of swap is called an over-the-counter derivative (“OTC”) because it is customized, and the value is “derived” from the 3-Month LIBOR (Eurodollar) futures market.

Determining the Credit Spread and Swap Fee

Using the above assumptions, let’s assume the market swap rate at the time of the fixed-rate offer is 3.10%.  The swap rate is an approximation of the lender’s cost of money and market expectations of where LIBOR will roughly average over that period of time.  To determine the credit spread the bank is charging, from our assumptions above, take the quoted fixed rate and subtract the swap rate:  5.75% – 3.10% = 2.65%.  In this case, 2.65% represents the lender’s gross credit spread.  If we change the amortization to a fixed principal payment for 10 years, the swap rate is 3.05%.  Obviously, a 20-year mortgage style amortization schedule means a lower monthly payment.  The yield curve is very flat at present, thus one needs to be cognizant that term rates in the current interest rate environment will be only a few basis points apart.  This means LIBOR is expected to average at about the same rate for 3 to 10 plus years.

An apples to apples comparison: 5.75% fixed compares to 1-Month LIBOR + 2.65% floating.  It’s that simple?  Not really.  The present value of 1 basis point (aka “PV01”) for a 10-year, level principal, fully amortizing loan is $4,658 and the PV01 for the 10-year deal with a 20-year level payment is $7,477.  The longer amortization schedule has more exposure if term interest rates fall.  Even though there is more risk to terminate a swap that amortizes over 20 years, the lower payment needs to be taken into consideration as a benefit.  While the difference in the all-in fixed rate for the 10-year term/20-year amortization (“10/20”) and 10-year term/10-year fully amortizing (“10/10”) is only 5 basis points, a 1 basis point increase in term rates will cost the borrower either $7,477 or $4,658.

There is one additional risk to consider: the bank is taking more risk by fixing a loan for 10-years amortizing over 20 years than by executing a fully amortizing 10-year pay fixed swap. This is a very important point to understand because the additional risk the bank is taking will be embedded into the swap rate or higher credit spread.  The calculation to quantify the additional risk is quite complex with many variables, and some of the reasons are not related to interest rate risk.  The bank may have discounted one service only to make up it by raising the swap rate.

Consider an example we come across all the time.  A bank adds 30 basis points (“bps”) to a 10/10 swap; the bank’s fee is:  30 x $4,658 (the PV01) = $139,740 and if 30 bps is added to a 10/20 swap the fee is $224,310.  Is 30 basis points a fair spread? The justification for doing so isn’t transparent.  However, we do know the 10/10 swap spread should be lower.

What’s your Day Count?

Day count is often overlooked when comparing credit options, to a borrower’s detriment.  A $10mm loan with a fixed rate of 5.75% for 30 days and a day count Act/360 = $47,917 in interest, but if we change the day count to Act/365 the interest would be $47,260.   We all know there are more than 360 days in the year.  The difference over a year equates to $8,000. That’s not chump change.

The Importance of Payment Periods

Now we need to add another component to the mix and that is payment periods.  If you borrow $10mm and pay interest monthly, but your index is based upon 3-Month LIBOR you should assume the interest cost is going to be higher.  A dollar today is worth more than a dollar in 3 months.

Most CMBS and Life loans use the 10-year swap rate as an index to fix the borrower’s loan.  Payments are usually monthly, and the loan is amortizing.

Why should you care if the index used matches the maturity date of the loan and banks use the swap rate when a borrow requests a fixed rate?  If you have stayed with us so far, the theme of this report will now make sense.

The swap pricing inputs are different than a bank balance sheet loan indexed to 1M LIBOR and fixed with a swap.  On a CMBS or Life loan. the swap index used follows the following inputs: the payment frequency is semi-annual, day count convention is 30/360 on the pay fixed leg and the floating leg is paid quarterly, and 3M LIBOR is reset quarterly using an Act/360-day count convention.  This equates to a higher fixed rate than if other, monthly inputs were used.  While this is market convention, a borrower should understand how the index is calculated when comparing to other credit terms.  The additional interest expense can be substantial.

Details, Details, and Details

All too often decisions are made by focusing on what appears to be the best offer when in reality the deal ends up being the most expensive because what appears to be minor details are in fact major and costly.

Everyone at some point in their life is guilty of having made a decision based upon price, later regretting their choice because of not taking into account the details.  Buying a computer is a great analogy.  In comparing 2 computers that appear identical, one is $500 less expensive.  You buy the cheaper one and later realize that was a big mistake because you didn’t make a proper “apples to apples” comparison.

A $500 mistake isn’t a big deal but comparing terms to borrow millions of dollars is a huge deal.  $500 is a rounding error.

Many borrowers feel they have the knowledge and experience to make the right borrowing and hedge decisions.  The reality is most borrowers are experts in their line business but know just enough to be dangerous when it comes to hedging or borrowing.

It takes at least 2 years for a derivative analyst to have enough basic experience to understand the market.  We should assume a banker or commercial real estate broker has to have at least the same number of years of on the job experience.

It’s all in the details and not hiring experienced consultants who understand the subtle nuances is a mistake.

Current Select Interest Rates