Why Hedge Before Rates Fall?

By Kevin Morse, Managing Director

Be a Smart Shopper

With U.S. Treasury yields hitting new 15-year highs, driven by continued strong economic news and Fed Governor warnings of additional rate hikes, this may seem like an odd time to be discussing rate hedging strategies for falling interest rate cycles. However, much like the Christmas decorations that I saw in Costco in mid-September, ‘tis the season to plan, beat the rush, and take advantage of preseason “sales”.

When were rate caps at their cheapest? Look back to the Fall of 2021 – just a few months before the Fed began their now 5.25% of rate hikes over an 18-month period. Do you think that the borrower that paid 20 bp’s for a 2-year, 1.50% LIBOR/SOFR cap in October 2021 (10 bps/year cost) regrets it today? For reference, 1-month SOFR is currently 5.32%. Their only regret should be that they did not buy a 3-year cap! To some, at the time, the cost of that rate cap seemed like a waste of money, as LIBOR had set at roughly 0.05% for the previous 18-months.

Likewise, with rates rising steadily and rapidly over the past 18-months and continued strong economic news along with “higher for longer” statements by the Fed being released on a weekly basis, now may seem like a ridiculous time to be hedging against falling rates. On the contrary, this makes it the perfect time – just like those post and pre-holiday sales – to consider ways to take advantage of the next turn in the market cycle.

“But,” one may ask, “how can I, safely and prudently, buy a hedge to benefit from falling rates? I can’t just go to Costco or Walmart and get one!” Alas, this is where the Christmas decoration comparison ends. Do not fret, though. Your experienced Rate Hedge Advisor, like the ones at Derivative Logic, can provide expert advice and lead the transaction process.
Are fixed rate loans safer for all real estate assets?+

Put your needs into context

First, examine your revenue stream. If you have long-term, fixed leases on your property – such as a typical industrial or office property – then, yes, having fixed debt payments over the same term can lock-in revenue spreads, providing income certainty.

What about assets like hotels where the room rates reset every night? Do room rates or occupancy generally follow the prevailing economic conditions – meaning does overall income from the property weaken during declining economic cycles and increase during high economic growth periods? If so, that sounds like what floating interest rates do as well! Thus, having floating rate debt exposure on these type of assets may be considered a natural hedge to help maintain profit margins. The same analysis may apply to your multi-family property as well, which has frequently resetting unit rents. However, a full analysis into the rate and rent correlations for each multi-family facility needs to be completed, given regional differences and possibility of local rent control laws.

What moves can I make?

So, what if you currently have a fixed rate loan (and this includes floating rate loans with deeply in-the-money caps); how can you quickly and efficiently convert all or a portion of it to floating?

Here are a couple of ways:
1) Buy interest rate floors. Like interest rate caps, but inverse, a borrower could buy an interest rate floor for an upfront premium. Owning an interest rate floor on a fixed rate obligation converts the effective borrowing cost to variable when the index falls below the floor strike rate.

That is because a borrower will pay the contracted fixed rate on its debt obligation; however, when the variable index on which it bought a floor falls below the floor rate the borrower is paid the difference. Hence, lowering its all-in debt cost during that interest period. When the variable index rises above the floor rate, the borrower receives nothing on the floor and is left with its loan fixed rate cost – meaning that there’s no risk from rising interest rates, other than the foregone upfront floor premium paid.

An important note: many floating rate loans issued over the past year-and-a-half have embedded floors in them, which means that the borrower can’t enjoy the full benefit of falling interest rates. Their loan rate will float down to the floor rate in the Note, but no further. In those cases, borrowers may buy a rate floor struck at the same floor rate in their loan, allowing them to take advantage of lower rates.

In today’s market, the cost of SOFR floors has come down significantly as the expectation of near-term Fed rate cuts has waned. For reference, a 2-year, 4.00% SOFR floor costs roughly 65 basis points, or approximately 33 basis points on an annualized basis. Perhaps a good relative value hedge against a recession.

2) Fixed-to-Floating Interest Rate Swap. Most are familiar with the common application of interest rate swaps – swapping a variable rate loan to a fixed rate (for a primer on rate swaps, start here). However, were you aware that you can also swap from fixed to variable? Many in the industry refer to this as a “reverse swap”. Rate swaps are typically traded with no upfront fees. So, a reverse swap allows a borrower to convert their rate exposure from fixed to floating with no upfront cost.

The catch with a swap is that each party takes on the credit risk of the other, since each is obligated to periodically exchange rate payments to the other over a set period of time (with a rate cap or floor, the purchaser makes an upfront payment and has no further obligations over the life of the contract; thus, there’s no credit risk to be underwritten). Hence, rate swaps are usually only available from the bank that holds the loan, as they will cross-collateralize the swap credit risk with the loan’s deed of trust. Without that collateral, a bank will not offer a swap. So, for loans with non-banks or banks that don’t have a swap desk, a reverse swap will likely not be an option.

Flexibility is how to tame the yield curve

Recently, the yield curve (the difference between short term and long term rates) has flattened out dramatically from a sharply inverted curve – i.e. short-term and long-term rates are fairly similar now, where short-term rates were recently much higher than long-term rates. Currently, the fixed rate on a 2-year reverse swap would be approximately 4.85% vs. today’s 1-month Term SOFR rate of 5.32%. This means that if the Fed cuts rates by 50 basis points, the floating rate payer would be in the money.

With both rate floors and swaps, one of the biggest advantages is their flexibility. Keep in mind that one does not have to swap or buy a floor on the full loan amount, nor for the full term of the loan. If one is only comfortable taking on a limited amount of variable rate risk, then they can just swap a portion of the loan amount and/or for a portion of the term. For example, one could swap 50% of the loan amount and effectively leave the other 50% fixed. In addition, if one had a 5-year remaining term on their loan, they could still do a fixed-to-floating swap for 2-years, leaving the back end of the loan fixed to minimize the floating rate risk term.

Bargains for those who plan ahead

Like a smart holiday shopper, savvy investors plan ahead and know when to find the best deals. They also build great teams around them to help create and execute their strategy and protect their assets. So, remember, you are not on your own to figure all of this out. 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.