Rate Cap, Swap and Collar: A Cheat Sheet to Managing Rate Risk

Update by Kevin Morse, Managing Director and DL Advisors, Dec 22nd, 2023.

From our conversations with borrowers over the years, we are consistently asked what hedging strategy makes sense for mitigating interest rate risk. Sometimes the borrower feels that they have no choice in the matter, because the lender requires the borrower to purchase a specific derivative. In many cases, however, a required hedge can be structured to satisfy the requirements of the lender but at a lower cost or risk to the borrower.

Often a borrower will say “We are very conservative” which in their mind is another way of saying they just want a fixed-rate loan. This simple approach is frequently achieved by borrowing at a variable rate and then fixing the rate on the entire loan amount for the full term with an interest rate swap, a strategy also known as “Fix it and Forget it”. For some, doing so makes the most sense given the risk profile of the asset’s revenue stream, the borrower’s plans for the underlying asset, or because of a view on the future direction of interest rates. For others, Fix it and Forget it can actually add risk to their business profits, expose them to large prepayment costs, and place the enterprise at a competitive disadvantage. Hence, it may be more prudent to hedge only 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.

Also understand that swaps aren’t the only way to mitigate interest rate risk. There are many more tools available to efficiently and effectively reduce interest rate risk. In the following, we’ll highlight these less utilized tools which can allow borrowers to achieve their goals of mitigating the risk of rising rates while allowing them to benefit from them falling. The right tool to use will always be determined by several factors, including current market conditions (i.e. prices), the risk profile of the business’ profits, and the expected hold period of the asset.

Interest Rate Swaps

As alluded to earlier, interest rate swaps are the most widely used interest rate hedging tool in the corporate finance world. There is no upfront fee to enter into a rate swap. They provide a great deal of hedging flexibility that fixed rate loans do not. For example, they allow a borrower to only fix a portion of their debt and/or fix it for just a portion of the loan term. In addition, the early termination (think of loan prepayment) provisions of a swap can be highly advantageous versus a fixed rate loan prepayment penalty, yield maintenance, or defeasance provision.

However, swaps may not be for everyone. For example, rate swaps, like fixed rate loans, preclude the borrower from benefiting from falling rates over time. This is very important if your business’s revenues tend to follow general economic cycles – i.e. revenues grow when the economy is booming and shrink during recessions. Think of industries in discretionary spending categories, such as hospitality, advertising, luxury goods, manufacturers etc. If that’s the case, then floating rate debt is a natural hedge, as interest expense tied to a short-term index, like SOFR, may correlate closely with revenue swings, helping to maintain profit margins.

Also, swaps may not be available to all borrowers. Because rate swaps are contracts for two parties – typically a counterparty bank and a borrower – to exchange interest payments over a set period of time, the swap counterparty bank takes on the credit risk of the borrower, its counterparty, that it will meet its contractual obligations to make those required payments. This risk is typically cross collateralized with the security, such as a deed of trust, of the underlying loan being hedged. Thus, rate swaps are most often only offered by the bank which holds the loan, as other financial institutions can’t access the collateral to secure their risk in entering into a swap with the borrower. In addition, non-bank lenders, e.g., bridge lenders, don’t offer their borrowers swaps, as they don’t have the capital base to support it. In today’s financial markets, which are heavily served by non-bank lenders, such as debt funds and private capital, many borrowers are not able to utilize interest rate swaps to hedge their rate risk, and have to therefore rely on other hedging vehicles, like interest rate caps.

Interest Rate Caps

Rate caps are commonly compared to buying an insurance policy on your interest expense. Like insurance, the buyer pays an upfront premium for the rate cap. The cost or rate cap premium is determined by several factors. One of the obvious factors is the level of protection, or strike. The cap strike is similar in concept to your insurance deductible, and the premium one pays for the cap or insurance policy is largely dependent on the amount of risk one is willing to take. The higher the cap rate or deductible, the lower the cost of that insurance; however, the greater risk one takes.

The advantage of a cap is that the borrower maintains the ability to benefit from short-term rates being lower than fixed rates during the term of the contract. In addition, because the borrower’s only obligation under a rate cap contract is to pay the upfront premium, there is no credit risk or collateral to be considered by the cap bank. Thus, the cap bank does not need to hold the loan to be able to offer a rate cap, avoiding the limitations of a swap.

Like swaps, however, rate caps may not be the best solution for everyone either. For many, the upfront premium required can seem prohibitive, or at least, not worth it. As with regular insurance, most borrowers, or their investors, don’t like to write big checks for something that they feel they’ll never use. However, in a case where the Fed hikes rates 5.25% within 18 months, borrowers that owned rate caps sure were relieved to have the protection. So, often the decision of whether to use a rate cap or swap to hedge interest rate risk comes down to a borrower’s risk tolerance for rising rates, need for interest expense elasticity during economic contractions, individual expectations of future rate movements, and, of course, if rate swaps are even available to them due to credit.

Interest Rate Collars

To help lower the upfront cost of a rate cap, interest rate collars are frequently introduced. A collar is simply the combination of a borrower purchasing a rate cap and “paying” for it by simultaneously selling a rate floor. Inverse to a cap, a floor is a contract where the seller gives up the benefit of the variable rate falling below a certain level (the floor strike). The most common version of a collar is a “No-Cost Collar”, where the cost of the cap is equal to the value of the floor, netting each other out, and no upfront payments are exchanged.

The result of the collar is that the borrower’s interest expense will float within a range up to the cap strike but not below the floor strike. A collar is attractive to one that wishes to maintain some variability in their interest expense with protection against excessive rate increases; but, rather than writing a big check for that protection, they are willing to forego some of the benefit of falling interest rates below a defined level. However, the attractiveness of collars is largely dependent on the yield curve and the market’s expectations of future interest rates. In steep yield curve environments, where the market expects rates to rise sharply over time, caps are very expensive, and floors have little value; so, it is difficult to structure a collar with appealing ranges. When the yield curve is flat or inverted, like today, collars may make sense. In a market that expects rates to be stable or fall over time, floors are much more valuable relative to caps, and very reasonable collar ranges can be offered.

On the credit front, collars are similar to rate swaps. Because the borrower is selling the floor, it has an obligation to make payments over time should the floor strike be triggered. Thus, like swaps, the bank offering the collar must underwrite and secure the credit risk of the borrower and asset, meaning that collars can generally only be provided by the bank holding the loan.

Bottom Line

Interest rate hedging tools, like swaps, caps, and collars, offer borrowers nearly unlimited ways to manage and diversify their risks. No borrower should settle for simple, like the Fix-and-Forget approach. Be aware, though, that the interest rate market is dynamic. Market sentiment – i.e. pricing – is constantly changing and what was the most cost-effective and prudent hedging strategy a year ago, may not be today. Being able to quickly evaluate and assess what is available, effective, and a fit with the goals and outlook of the owner, requires experts that devote their days to consistently watching, analyzing, and trading in the markets. These individuals can provide timely, clear, and simple solutions, ensure fair pricing, and assess that contracts are appropriate for the borrower. This is how experienced interest rate hedge advisors, like those at Derivative Logic, offer deep education and prudent risk management alternatives, resulting in peace of mind and economic value to your business. Before entering into any rate hedging agreement – or deciding not to – please discuss it with a qualified advisor. You will be very glad you did.

Call for Help

At Derivative Logic, our expert advisors, each with decades of experience in the interest rate derivatives market, are standing by, ready to help. Give us a call today for a free initial consultation at (415) 510-2100.