Regardless of your or our personal opinion, it’s undeniable that interest rates are steadily climbing higher. As borrowers contemplate the pain a world of higher rates will bring, one thing is crystal clear: the cost of financing is becoming more and more expensive; higher rates are likely to raise financing costs and reduce asset values, especially in commercial real estate. As such, we’re routinely asked, “How can I lock-in long-term rates today on an expected future financing occurring in six months, one year or beyond?” Sure, long-term interest rates are still attractive by historical standards right now, but the borrower’s dilemma is the debt they’re contemplating taking on doesn’t exist yet, or, in a common scenario, the project is in a construction phase and the close of the eventual term financing is one or two years in the future.
What’s a Borrower to Do?
Prior to the 2008 credit crisis, many borrowers typically hedged the interest rate risk on future term debt with a derivative to lock-in the Treasury or swap rate (aka a “T- lock” or “forward starting swap”). These derivatives obligated the borrower to pay or receive depending upon how the hedged, fixed interest rate performed versus market rates. Life was good, until the credit crisis hit, which resulted in term interest rates plunging and long-term credit markets drying up. With no chance of securing term financing, and owning hedges that were suddenly unnecessary, borrowers who had entered into Treasury locks or forward starting swaps had to unwind the derivative contracts at large losses, and often with devastating financial consequences.
Is there a better way?
The need to hedge future term financing has come back vigorously, and fortunately, recent financial market conditions allow for a much better way to hedge this risk by employing an interest rate swaption.
Hang in there with us – while the word “swaption” is a bit confusing and maybe even a little intimidating, its advantages for borrowers aren’t: a swaption, for an upfront fee, buys the borrower the right, but not the obligation to enter into an interest rate swap on a defined, future date. With interest rates on the rise, borrowers fear that their future financing needs will come with a much higher, and thus more costly, interest rate than what’s available today, and hence wish to shelter themselves from this possibility. Swaptions provide this shelter. For an up front cost, a swaption allows a borrower to cap their fixed term financing rate at a level based on current low rates (called the “strike” interest rate), to hedge that future financing need.
It typically plays out something like this:
- Situation: Let’s assume that your current bank loan will mature in 2020, you need to secure permanent financing on or before that time.
- View: You fear that interest rates are on the rise and your future financing will be at a significantly higher interest rate than the bank loan you have today.
- Strategy: Even though the specifics of your future financing aren’t defined yet, you decide to employ a swaption to take some of the sting from what you believe will be a world of higher interest rate choices.
If interest rates are higher than the swaption’s fixed, “strike” rate in 2020, the swaption will compensate you for the difference. Conversely, if interest rates are lower than the swaption’s fixed rate, you receive no compensation, and take the upfront cost paid for the swaption as a sunk cost of the protection. However, all is not lost, as in essence, you’re compensated via a lower term rate. Sort of like buying an auto insurance policy and being happy that you never needed to use it.
Just like a rate cap, swaptions can be highly customized, in that term, notional, “strike” rate (aka your pain threshold), and dates can be tailored specifically to the future financing being contemplated. The swaption is always an asset to the borrower, providing an efficient hedging solution to limit the exposure to higher long-term rates or a term loan liquidity crisis.
What’s the downside?
Swaptions offer an alternative to T-locks and forward starting swaps to hedge future long-term fixed rates. Their key attributes are:
- Flexibility. The main difference between a forward starting swap and a swaption is that with the former, the borrower is obligated to enter into a contract to exchange a floating rate for a fixed rate. A swaption is simply the right, but not the obligation, to enter into a swap contract. In most cases, borrowers hedging with swaptions don’t enter into a swap through the swaption’s exercise; they merely “cash settle ” the swaption, taking their gain when long-term rates are higher than the swaption’s fixed, “strike” rate.
- Defined Downside. Swaptions also offer more predictable outcomes than T-locks or forward starting swaps. When employing a swaption as a hedge, there are only two possible outcomes: 1) at maturity, if term rates have risen above the swaption’s set “strike” rate, the swaption is cash settled to compensate the hedger, or, 2) if rates are lower than the swaption’s strike at maturity, the swaption expires unused and the borrower locks in a rate on the term debt at the lower, more advantageous market rate. The downside? The borrower paid a known, upfront fee for the swaption; if it isn’t needed at the end of the day, the fee is a sunk cost.
Swaptions Make Sense for Non-bank Loans
Many real estate term loans are through life insurance companies, CMBS, or conduit programs rather than a bank. Generally, these credit facilities are priced using a swap index which matches the term of the loan. Swaptions provide an efficient way to protect against rising rates for future funding needs for loans indexed to swap rates. For deals that will price off Treasuries, the swaption includes a component that may track some of the change in credit spreads over time.
Define Your Pain Threshold
Whether borrowing at a fixed or floating interest rate, borrowers should always have a defined, “worst case” cost of funds. This pain threshold is the starting point of any financing analysis as well as any conversation about hedging interest rate risk, as it has a huge impact on the choice of hedging vehicle and costs.
The type of hedge used to lock-in future funding isn’t a simple decision. For various reasons, a T-lock, forward starting swap or swaption may be the best solution based upon the yield curve, credit stipulations, borrowers view, and cost of the hedge. T-locks are typically used for Life Insurance or CMBS funding, because those credit avenues do not have the capability to act as counterparty to a swap, however, a T-lock or forward starting swap may increase risk rather than mitigate it in certain situations. In evaluating a swaption as a candidate for hedging, there are numerous variables which directly impact its cost, and therefore determine its attractiveness; amortization, dollar amount , time to maturity, level of protection, market interest rates and volatility to name a few, not to mention the spread charged by the counterparty bank.
Many of our public REIT and large corporate clients fear a future of higher interest rates and are employing swaptions right now to hedge their rate risk. Curious about swaptions and how they can work for you? Given the variables and complexities involved, we suggest utilizing an independent professional, like us, to help determine if a swaption makes sense based on your specific goals and objectives. Call on us and put our decades of experience to work for you.
Current Interest Rates