Currently interest rates are near historic low points and make long term borrowing attractive. On the other side is the bank that does not want to lend long-term at today’s rates. What can you do when the bank says no to fixed rate, long-term loans? It is called interest rate hedging and there are multiple ways to do it.
You can hedge through options traded on an exchange or you can purchase a hedge contract through a financial institution. As our clients want to hedge on actual term loans, this blog focuses on hedge contracts with a financial institution. There are four tools to limit your interest rate risk:
Swaps: this instrument fixes a rate that counters changes in a variable rate loan. If rates rise, they pay you, so your interest cost remains the same but if rates drop, then you pay them. The net of the transaction keeps your interest cost level.
Caps: this is a contract that caps how far you will allow your interest rate to increase before you start receiving compensating payments. This fixes the top rate on your loan. If rates drop, you don’t have to pay anything.
Collars: this is a contract that has a top and bottom to create an acceptable range. You agree to cap your interest rate but also agree to pay a minimum interest rate. You get upside protection but may pay above market interest rates if rates decline considerably.
Structured Collars: this is a collar with specific terms and conditions for a specific need.
Here is an example of why and how a hedge might be used. Acme Manufacturing needs a new building and it must be built to suit their specific operations. Their bank offers a variable rate construction loan and a variable rate 20- year mortgage on the finished building. The construction will take 12 months, cost $20 million and moving in will take another 30 days. The President of Acme is concerned that interest rates will increase and could increase to a level that the company would have difficulty making the increased payments.
They have two possible alternatives: buy a hedge contract for the construction loan and one for the mortgage. Or no hedge during construction and then take out a hedge on the mortgage. Their bank offers only variable rate loans. Through a broker, BBMA bank in another state, offers them a fixed rate hedge contract for the construction loan at 1% above the current market rate. They also offer a hedge to fix the mortgage rate at the current market rate for a 30-year mortgage, which is .75% above the current 20-year mortgage rate. The up-front fee for both is 15 basis points.
Acme decides that this hedging arrangement reduces their interest rate risk to a manageable level and the cost is not prohibitive. They agree to the loan terms with their bank and sign an agreement with BBMA to begin hedging once the actual construction starts.
C Squared Solutions offer fractional CFOs and COOs for growing businesses. We have successful track records in helping owners analyze situations like this and securing funding. Give us a call and let’s discuss your concerns.
