Managing Debt Costs
Imagine This Scenario:
Your company’s products have gained wide market acceptance - so much so, in fact, that backorders are piling up and customers are screaming. You decide it’s time to bite the bullet and build a state-of-the-art manufacturing facility at a cost of $5 million. It’s an opportune time to borrow because interest rates are at an all time low and the bank offers you a loan with a rate of prime plus one percent. You remember, however, what happened when you financed your home with an adjustable rate mortgage. It wasn’t a pretty sight.
So, what do you do? Is there a way you can take advantage of today’s low interest rates while locking in a maximum long-term borrowing rate? How can you avoid the traps of a variable rate loan, yet take advantage of rates when they are low? One possibility to help you achieve your goals might be to use Interest Rate Caps, Collars and Swaps.
Interest Rate Cap
Interest rate Caps are perhaps the easiest to understand. Simply put, you pay the bank for an agreement that limits the maximum interest rate you will pay on your debt. This protects you in a rising rate environment, but does not prevent you from benefiting from lower rates in a falling rate environment.
For example, assume you take out a prime + 1% loan that is payable over five years and you think interest rates will go up during that period. Let’s say your initial rate is 9% rate. You also buy an interest rate Cap that limits your maximum interest rate to 11%. If the prime rises to 14%, in the absence of that Cap you would pay 15% interest on the loan. Since you bought the Cap, however, your rate will only be 11%. Suppose the prime rate drops to 4%. You benefit from the drop because the rate you pay will be 5%.
The price you pay for an interest rate Cap is determined by negotiation when the Cap is issued.
Interest rate collar
Just like you can buy an interest rate Cap to protect against rising interest rates, you can also purchase a “Floor” that limits the rate you pay on the downside. Unlike a Cap, you are the seller of a Floor and the bank from which you purchased the Cap is the buyer. By protecting against interest rate risk on the high side (CAP) and foregoing some benefit from a decrease in rates (Floor), you create a Collar by surrounding your risk with upper and lower rate limits.
Interest Rate Collars limit the cost of protection from interest rate increases, sometimes to nothing. Generally, a Collar can be sold back to the bank, but you could incur a loss.
Interest Rate Swaps
Interest rate swaps are contracts entered into by two parties where each party agrees to make interest payments to the other based on a notional or fictitious amount of principle. For example, if you want to enter into a swap where you pay a fixed rate of interest, say 5%, on $1 million to limit your exposure on a floating rate loan, in year 1 you would pay $50,000 in interest to the other party. The other party pays you interest based on the rates in effect during that same year.
The swap we just discussed is called a Fixed-for-Floating Rate Swap (same currency). Typically, the floating rate is pegged to widely quoted rate index; the most used being the London Interbank Offered Rate (Libor). This type of swap is generally used to convert a fixed rate asset or liability to a floating rate asset or liability and vice versa. Let’s look at how you limit the interest on your $5 million building. One strategy would be to enter into a Fixed-for-Floating Rate Swap (same currency). Beware, though, because there is a cost to entering into interest rate swaps - and a real possibility of losing even more in the long run.
You can also enter into a Fixed-for-Floating Rate Swap (different currency). In this case, you enter into the swap, but payments will be in different currencies. For example, you may pay a fixed 5% on a notional 10 million USD in exchange for a floating rate of Libor + .25% based on 7 million in British Pounds. Unless you are involved in international trade, you would rarely utilize this type of swap.
Another swap type is a Floating-for-Floating Rate Swap. In this type of swap, two different indexes like Libor and Tibor (3-Month Euro Yen Interest Rate) are used. To further complicate things, you can also create such swaps in different currencies.
This article is not meant to be an exhaustive discussion of ways to minimize your interest costs. Rather, it is meant to introduce the notion that you can limit your exposure to increased interest rates in the right circumstances. While there are many advantages to limiting your cost of borrowing, there are some very significant downsides to Caps, Swaps, Collars and the like. The bottom line is that you can lose a great deal of money if you don’t make the right decision going into the contract. Before you enter into any type of hedging instrument, give us a call. We can help you look objectively at the economics of the transaction and assist you in determining if the investment is right for you.
Have a great month!