10 Nov How To Fix Your Loan’s Interest Rate
Everyone is familiar with the standard fixed rate loan. It is a fixed rate over a specified term for a specified amount. It is simple, transparent and you know exactly what you are paying for your loan for budgeting purposes.
What is not commonly known are the potential shortcomings that this basic vanilla structure ensues upon your capital structure and the magnitude of other arrangements that can be put in place to manage interest rate risk that maybe better suited to your needs.
Let’s briefly explore the pros and cons for some of the more prevalent structures available in the market.
Fixed Rate Loan
PROs – as above, it is simple, transparent and you know exactly what you are paying for your loan for budgeting purposes. The interest rate protection is clearly defined by the fixed rate being offered.
CONs – With a “normalised” yield curve, the fixed rates being currently offered in the market are generally at a significant premium to the variable rate. Should you need to break a fix rate parcel (paydown of debt, refinance, borrowing entity restructure etc), and the yield curve has fallen, you will be exposed to a break cost equivalent to the amount of the loan x the term of the loan outstanding x the interest rate differential in the yield curve at the time when the fixed rate was accepted vs where the yield curve is now. Hence, there is very little capital flexibility within this simplistic hedging structure.
Forward Rate Start
The scenario is that you believe that interest rates my increase in the future, but you want to take advantage of the current low rates. Or you will incur a loan sometime in the designated future that you seek to hedge. To achieve this, a forward rate start allows you to fix a rate that starts at a specified future date for a certain term and amount. An example would be fixing a parcel that started in 12 months’ time that was then fixed for a further 4 years. Hence, a five-year term would be 1 year variable then 4 years fixed.
PROs – You can enjoy the currently low interest rate environment before the interest rate hedge kicks in. Or you can manage the interest rate risk on a future loan that has yet to materialise.
CONs – To avoid being technical, the delayed four-year fixed rate will be priced higher than a straight 5-year fixed rate so you will pay a premium for the privilege. The same cons are also applied as the Fixed Rate Loan as well.
Interest Rate Swaps
This is effectively “swapping” a variable rate commitment for a fixed rate commitment. This product achieves the same interest rate hedge as a Fixed Rate Loan with a lot more sophistication and flexibility and is dependent upon using market rate linked products. The underlying interest pricing will always be variable, with the swap then sitting on top as the hedging component. At any given time, the swap is either “in the money” or “out of the money” depending on where the swap was originally traded at and where the current underlying money market is currently trading at. An example is the best way to explain the opportunity.
EXAMPLE – You have a $10.0m variable loan facility rolling every 30 days and you have been quoted that your variable rate is 2.00% p.a. You decide to hedge $4.0m for 5 years via the use of a swap and have been quoted 2.75% p.a. which you accept. At this point, every 30 days you will pay the bank the 2.00% variable rate on the $4.0m PLUS pay the bank an additional 0.75% for the swap that is “out of the money”. In 12 months’ time, the variable rate has moved up 50 bps so every 30 days you pay the bank the quoted variable rate of 2.50% on the $4.0m PLUS pay the bank an additional 0.25% for the swap that is still “out of the money”. In two years’ time, the variable rate has moved up to 3.25%. You still pay the bank the variable rate of 3.25% on the $4.0m but now the bank pays YOU 0.50% as your swap is now “in the money”. Overall, in all three cases, you are still paying your fixed rate of 2.75% as a net position.
PROs – Given that the underlying market rate loan is a variable loan, you can pay down and redraw this loan without impacting your hedge. In addition, swaps are tradable derivative products, so you can move your debt facilities between banks to secure better (variable) rate deals and bring your hedge across with nominal cost. Hence you maintain full flexibility of your loan capital through out the duration of your hedge.
CONs – If you do wish to pay out your loan in full, or reduce your loan amount permanently, you will be left with a residual derivative market to market position that is either “in the money” or “out of the money” potentially creating an over hedged position or a speculative position on the future direction of interest rates. If you are “in the money” you can sell down your hedge and receive credit funds. Unwinding an “out of the money” position will create a break fee equivalent to the derivative’s NPV loss.
Options – Caps, Floors, Collars, Spreads etc
An option gives you the right but not the obligation to buy or sell and underlying position – in this case an interest rate hedge (swap). Options are very sophisticated instruments in terms of understanding their pricing and realisable value at any given time. The price is a function of volatility, bond prices, time to expiry, amount, exercise price and current price.
PROs – Because options remove the obligation to participate in a hedge, they give you the ultimate freedom of choice depending on where the money market is trading at any given time. You would remain at a variable rate whilst the market is trading below the exercise price, then call upon the option once rates exceed the exercise price.
CONs – Put simply, the price. The premium paid for options can be considered quite excessive and are either built into the variable rate as a higher margin, or a direct debit from your bank account. Both of which impact the cash flow of the business. Options certainly entertain the more sophisticated end of the market and should only be considered on solid independent advice.