Managing interest rate risk with swaps
Flexible tool can help protect against rising borrowing costs
Many companies that finance their operations with floating-rate loans may be able to take advantage of a bank tool designed to limit their exposure to a rise in the cost of credit: an interest rate swap.
An interest rate swap allows you to synthetically convert a floating-rate loan obligation to a fixed rate, and offers flexibility in how you accomplish that conversion. Swaps also allow you to synthetically convert fixed-rate debt to a floating rate.
A swap is a contract entered into along with the original loan agreement. It involves no up-front fees. The borrower's specific obligations under the original floating-rate loan remain, including the regular payment of interest according to the periodically adjusted rate. No principal is exchanged in the swap, and the original principal repayment terms of the loan remain intact.
Although the loan and swap contracts are distinct, they are tied together by offsetting payments, cross-collateralization and cross-default provisions.
So how does a swap effectively turn a floating-rate loan into a fixed-rate obligation? Under the swap, payments from the bank mirror the borrower's interest payment under the loan. The borrower then pays the net fixed-rate interest payment to the bank.
What kind of corporate borrowers can take advantage of swaps? Here are some general criteria.
- Loan size – As a rule of thumb, loans should be in principal amounts of at least $1 million with maturities of at least 3 years.
- Rate sensitivity – Borrowers who are sensitive to changes in interest rates based on their business model could remove the rate volatility through interest rate swaps.
- Stable debt service – Borrowers who prefer to budget for a stable monthly debt service may benefit from a hedging strategy.
- Construction loan or future funding – Borrowers anticipating a future funding can protect the associated future rate risk by entering into a swap. The most common example is a construction loan that will fund up over a certain period of time and be fully funded in the future.
- Balance sheet – Borrowers must qualify as an "eligible contract participant" under federal regulatory guidelines. Generally, that means having at least $10 million in assets or a net worth of at least $1 million.
- Credit strength – Execution of an interest rate swap requires credit approval by the bank providing the swap.
Interest rate swaps are a highly flexible financial risk management tool that can be customized to fit almost any interest rate hedging strategy.
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