Time to Terminate Your Swap? - Derivative Logic

Most borrowers never consider terminating or re-structuring their interest rate swap, regardless of its mark-to-market value. “Fix it and Forget” is a common refrain, but not a wise strategy. Hedging is dynamic and not static. Investors constantly review their assets to evaluate if the investment should be increased, sold in partial amounts, completely sold off, or the investment exchanged for another asset. Hedgers should follow the same strategy, but often don’t, to their detriment.

The following paragraphs are a review of several scenarios where unwinding an interest rate swap makes sense. Use it as your hedging playbook as you evaluate your refinancing options.

Assumptions:

$10MM Notional, 1M LIBOR, 10 Year term, non-amortizing swap. All valuations and interest savings described below are calculated on a present value basis. Valuations are as of 3-14-17, mid-market and do not include bank swap fees.

Termination and Re-structuring Scenarios

Credit Spread over 1M LIBOR – Most of the time, the ability to obtain a lower credit spread is a key factor in determining whether a swap should be terminated, even if the swap has a negative value. Reducing the credit spread by 1.00% over 10 years is a savings of $903,829 in interest expense. A swap executed 9-1-13 at a 2.75% swap rate has a Mark-to-Market (“MTM”) of -$324,207 with approximately 6 ½ years remaining. Just a 0.50% reduction in the credit spread is an economic savings, and entering into a re-structured swap starting 4-1-17 for 10 years offers a 2.37% swap rate, a difference of 38 basis points. The borrower doesn’t necessarily have to enter into a 10-year swap or use bank financing, however. The source of the new financing could be a Life Company, agency (Freddie or Fannie fixed or SARM), or CMBS. Call your commercial mortgage broker, investment banker and derivative advisor. Your debt advisor will evaluate the current credit facility and your derivative advisor will provide various hedge structures based upon proposed credit structures. That is why it’s important to include your credit and derivative advisor in any decision to restructure financing that impacts credit and interest rate risk.

Out of the Money Swap – As described above, even a swap with a negative value can offer an opportunity to reduce interest expense. But what about a scenario where the borrower wants to extend the maturity date of a swap executed 4-1-12 at a rate of 2.00% because they’re concerned term rates will be much higher in 5 years? By extending the maturity date another 5 years, the swap rate increases by 35 bps. The borrower is paying a bit more for an additional 5 years of rate protection. This is just one example for amending a swap which has a negative MTM. Icing on the cake is to obtain a lower credit spread on the underlying loan and extend the hedge.

In the Money Swap – Most borrowers who’ve entered into a pay fixed swap have never experienced a swap with a positive market value. A swap executed 7-1-16 has a value of $859,653 with more than 9 years left. The hedger can terminate the swap and receive $860k, go to Las Vegas and place a bet on black at the Roulette table. Almost a 50% chance of doubling the termination value. Once the swap is unwound, the borrower is now subject to an unhedged, floating interest rate and has lost all the swap’s value or doubled it. We don’t advise on gambling with the swap value because our role is to assist borrowers manage risk and not speculate. There are several strategies on what to do with a positive value swap. Do nothing, buy an interest rate cap, pay down the loan, or set up a reserve fund. These are just a few ideas. What’s a borrower to Do? Seek advice from an independent derivative advisory firm, commercial mortgage broker, or investment banker. The roles are similar – leveling the playing field by structuring credit and interest rate strategies to meet the borrower’s unique goals and objectives.

Regulations require the Bank to Disclose Mid-Market – What does this mean when terminating a swap or amending an existing swap? The mid-market price is between the bid and offer. If you are terminating a swap the pricing will be x basis points from mid or what one would call the bid. What should the difference in basis points be from mid? A very important point to keep in mind is the bank marked up the swap based upon the risk of rates falling over the life of the swap and the hedger defaulting on the loan and the swap. Terminating a swap relieves the bank of any risk and substantially increases the bank’s rate of return on the swap. Most hedgers believe the bank loses money if it will have to pay to terminate the swap. Does a stock broker who sold you Apple stock at $105 lose money when you sell it back at $135? They make money on the purchase and sale. The same is the case with a swap. THE BANK NEVER LOSES MONEY ON A SWAP. Hedgers should be aware that the bank’s profit mark-up (spread over mid) on a swap is recognized on day one. That’s the beauty of present value accounting for banks. Recognize the profit on a 10-year swap today and not have to give it back if the swap is terminated in 5 years. That’s not possible with buying a stock or bond. There is no refund!!!!! What should the spread below mid be when a termination occurs? Without a live pricing system and an independent advocate, you will never know.

Floating – Is fixing all floating rate risk the right strategy? What about unwinding 50% of a swap which has a positive market value? Why do some borrowers feel floating is risky? What are the risks with fixed rate debt? What is the right mix of floating and fixed rate debt? Whether a hedger’s swap has a positive or negative market value, there should always be time to review debt and hedge structure, and if there really is no time, hire a firm with experts to watch their back. Let’s not “Fix and Forget.” The interest rate market is constantly moving and credit spreads for certain asset classes widen and tighten along with it.

Seek Independent, Qualified Professionals

Ask your mortgage broker, investment banker, attorney, or accountant who to call for help managing interest rate risk. Ask your derivative advisor for contacts with expertise in a particular industry group. Good advice isn’t quantifiable in relation to savings, it’s what you learn from hiring experts to guide you through the decision-making process that’s invaluable. Individuals at our firm have a total of over 100 years’ experience in the capital markets. What those 100 years have taught us is that transactions executed or disregarded without qualified independent advice often lead to ill-informed decisions and, sometimes disastrous results.

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