Traditional Fixed Term Borrowing vs “Synthetic Fixed Rate” Term Borrowing
What is “Synthetic Fixed Rate Borrowing”?: A creative way of obtaining fixed rate borrowing at desired terms with lower overall fixed rate costs. Rather than borrowing with a traditional fixed rate term note, commercial borrowers can borrower on a VARIABLE RATE basis and then use an INTEREST RATE SWAP to fix the rate.
Among the most popular of derivative hedging instruments, interest rate swaps are used by corporations, government entities, and financial institutions to manage interest rate risk. Swaps can be applied to a wide range of hedging needs and can be easily tailored to match a specific risk profile. Their simplicity and flexibility have made them the workhorse of the risk manager's toolbox.
What is a “swap”?: A swap is an agreement to exchange interest payments for a stated time period (the borrower pays a fixed rate of interest, the bank a floating rate). The swap agreement is a separate contract from the loan and its terms are customized to meet the borrower's specific risk management objectives (terms include start and end dates, settlement frequency, the notional amount on which swap payments are based, and reference rates on which swap payments are determined.
How is it used?: Generally commercial borrowers will use the swap agreement to hedge against rising interest rates and reduce borrowing costs. Among other applications, swaps give commercial borrowers the ability to:
- convert floating rate debt to fixed
- cap a floating rate
- lock in an attractive interest rate in advance of a future funding
Benefits of the “Synthetic Fixed Rate” strategy: The primary benefits to borrowers of the synthetic fixed-rate loan compared to a traditional fixed-rate loan are:
- Lower fixed rate. Variable-rate borrowing with a swap frequently costs less than a traditional fixed-rate loan.
- Longer term: The synthetic fixed rate strategy allows banks to commit to longer terms vs the traditional term note (e.g. 10 years vs 5 years)
- Flexible structuring. Borrowers can choose to fix a portion of their debt (e.g. fix 80% of borrowings, float on the other 20%)
- Two way prepayment provision. Prepaying a traditional fixed-rate loan often requires paying a yield maintenance prepayment penalty, which can be significant even when market interest rates do not change. Prepaying variable-rate debt does not involve a material yield maintenance prepayment penalty, but prepayment may require a swap termination payment, which can be either a cost or a benefit to the borrower based on market rates. Some borrowers prefer to take swap termination risk since it relates to market interest rate changes without an extra payment to maintain a yield.Swap rates higher = benefit to the borrower
Swap rates lower = cost to the borrower
Common Swap Structures
The most basic swap is an exchange of floating-rate interest payments for fixed-rate payments. For example, a company which has cost-effective floating rate bank debt can use its floating rate borrowing power to create fixed rate debt. To do so the company enters into a swap to the target maturity (e.g. five years), agreeing to exchange floating-rate payments based on LIBOR for a five year fixed rate. Through the swap the company avoids the costs of issuing long-term debt, gains the protection of a fixed rate, and retains the cost advantage its bank debt enjoys.
Other Typical Swap Applications Include:
Fixed-for-floating swaps which allow a company (generally larger corporations that issue bonds or private placements) to lock in liquidity through issuing long-term debt, but to pay a floating rate. The swap positions the company to gain from a decline in short-term interest rates.
Forward-starting swaps to lock in the rate today for an asset or liability to be created or sold in the future. A company that plans to borrow at a future date can use a forward-starting swap to hedge the future funding. Forward-starting swaps allow companies to take advantage of favorable rates when the market offers them - not just when coming to market. Locking in the forward financing costs or investment yields allow the hedger to accurately budget cash flows and expenses related to future projects.
Swaps with imbedded options to fit unusual financing structures. For example, borrower may anticipate possibility of an early debt repayment and may choose to include a “call feature” into the swap.
Other swap structures can be created to meet different needs. This flexibility is why many companies find interest rate swaps are an invaluable tool in managing the financial balance sheet.