Interest Rate Swaps Explained

What is an interest Rate Swap?

Most companies borrow money from lenders agreeing to pay the lender interest periodically, say monthly, at a rate which is based on a benchmark lending rate, often LIBOR or Prime, plus some interest rate spread that is based on the individual credit condition of the borrower, say 3% (typically called 300 basis points or “bps”).

Benchmark Lending Rate – 3 Month LIBOR           0.50%

Borrower’s Individual Interest Rate Spread          3.00%

Total Borrower’s Floating Interest Rate                  3.50%

A company’s individual interest rate spread may vary under the terms of the loan agreement if the borrower’s credit quality improves or deteriorates, but these changes are typically under the control of the borrower.

The benchmark lending rate, LIBOR or Prime, also determines the interest rate that a company pays but the borrower really has no control over these benchmark lending rates.

In practice, a company’s annual interest rate is calculated frequently, every quarter or month, then applied to the outstanding loan balance for the period.  Therefore, the interest rate and the interest payment may fluctuate period to period.

Some variability period to period is common, even expected. The problem is with too much variability.

A rise in the underlying benchmark interest rate, typically for reasons entirely distinct from the borrower’s  business, can occur unexpectedly and rapidly.

Because borrower’s interest rates are determined periodically, monthly or quarterly, changes in the underlying benchmark interest rates impact a company rapidly, maybe before a company can adjust its own business, changing pricing, costs, etc.

How to Fix the Benchmark Interest Rate?

An interest rate swap is a contract which a company with enters with another entity, typically a lender, to enable the borrower to avoid changes in its benchmark lending rate.

Arranging a swap in order to eliminate a variation in the benchmark lending rate costs the borrower something extra.  The amount extra depends on market conditions and on the period for which the rate is fixed.

Let’s assume that this borrower will enter into a swap for five years.  A five-year swap in this example costs the borrower 1.2% per year or 0.1% per month.

In this contract, a company agrees to pay the lender a fixed amount of interest each payment period, in order to lock in, or fix the interest rate on its benchmark lending rate.

Borrower’s Individual Interest Rate Spread          3.00%

Plain Vanilla Swap Rate for 5 Years                           1.20%

Total Borrower’s Fixed Interest Rate                       4.20%

 

After the swap, the borrower will pay its lender 4.2% per year with no change over the 5 years as long as the borrower’s individual interest rate spread remains 3.00%.

The other party to the swap, again typically a lender, takes the risk that the benchmark lending rate may rise in return for the borrower’s extra payment.

Why would a company use a swap?

The primary reason a company would enter into a swap is to eliminate the risk of a rise in the underlying benchmark interest rate.

In the example above, the borrower which entered into the swap would pay 4.2% vs 3.5% before when it had a floating interest rate loan.  The extra cost is the cost to avoid the risk of a rise in the benchmark interest rate over the next five years.

A borrower can choose to fix the rate on all its floating rate debt or simply a portion of the total.  If a company’s debt outstanding fluctuates based on seasonal or other cyclical factors, a company may fix the rate on its minimum level of floating rate debt.

Another reason is that a company can unwind or revise a swap without repaying the underlying borrowing which is not the case if a borrower enters into a simple fixed rate loan.

Yet another reason cited is that the swap market prices its contracts with less credit risk included so that a middle market company may obtain a fixed rate loan at a lower cost than it could obtain from a lender in one fixed rate loan.

Why not enter into a swap?

A contract is a contract.  Once the company enters into the swap, changes in the amount of the borrowings or in other terms may cost the borrower to revise the terms of the swap.  The cost is dependent on the market conditions (i.e. prevailing interest rate)  at the time of the change.  Therefore, there may also be a benefit to the borrower upon making a change if prevailing interest rates are higher.

For example, it the total borrowings on a company’s loan drops due to a slow economy, the amount of the swap remains as initially agreed.  This risk prompts some companies to enter into a swap on a portion but not all of its borrowings leaving a cushion for cyclical or seasonal swings in the amount outstanding.

Also, if interest rates should fall further, the borrower’s rates would be fixed so the borrower would not benefit from the interest rate drop.

While there is no certainty on interest rates, today’s rates are at historical lows so the risk of a major reduction from here is small.