As sequels go, very few movies have been hyped as much as this one. Catching Fire, the latest installment in the Hunger Games franchise, opened this past weekend to throngs of teens, tweens, and giddy parents, scoring $161.1mm in box office receipts for the 4th best domestic movie opening in history, as well as the best November opening weekend ever. Fans couldn’t wait to get a second helping of Peeta Mellark and Katniss Everdeen, giving director Francis Lawrence a bona fide blockbuster going into the Thanksgiving holiday weekend. The latest offering picks up with the stars’ triumphant return to District 12 on their victory tour, having survived a vicious fight-to-the-death tournament, only to realize that they will have to do it all over again. While sequels can sometimes leave a bad taste in your mouth, fans have judged their second serving of Hunger Games to be another deliciously entertaining experience. No doubt that as families gather this holiday weekend to give thanks for all that is good, they will celebrate with food, football, and Catching Fire, with many fans heading out to see this sequel a second time.
Following up on your first act can be a daunting proposition. From the director’s chair, there is pressure to go big, to strengthen the plot, characters, and special effects, and to turn holdout critics into cheerleaders. As a fan of the series, you want something new, but at the same time something familiar, and to be taken on a trip every bit as good as the last. Ultimately, both parties want to keep a good thing going, and follow up one success with another. Not surprisingly, this is the same view you have when it comes to managing your ongoing business risks. Having seen an interest rate cap through to maturity, you know a thing or two about managing exposure to rising rates now. You have choices to make when it comes to re-hedging those risks, and program improvements are a natural part of the process. Like any good director (or fan), you have many things to consider before the next installment of the hedging games.
Cap it again. If it ain’t broke, don’t fix it. That is the path many would take when contemplating that next hedge as the current deal matures. If you purchased a cap three years ago to hedge the first three years of a seven year floating rate loan, you have several excellent reasons to do it all over again. First off, three-year caps are less costly today than they were three years ago. This means you can either pay a lower premium, or you can purchase a lower strike cap or a longer dated cap for the same premium as before. Second, if your loan is amortizing, then your notionals today are lower than before, which may work to reduce your cap premium even further, giving you more choices still on strike and tenor. Finally, if you purchased your cap from your lender, you can also benefit from “shopping around.” Since interest rate caps are not a credit-intensive product, you may be able to get several cap providers to compete for your business this time around, possibly lowering the cost even more. Of course, there are a few reasons to consider your alternatives as well.
Swap it out this time. Your loan docs may have required you to do a hedge, and your previous hedge may have been a cap, but you may be in a position to do a pay-fixed swap this time around. Swaps necessitate that both borrower and lender be credit-worthy entities. In the eyes of your lender, you may be more credit worthy today than you were three years ago. Your lender’s exposure to you is now down to four years, and it’s likely that you have more equity in your underlying property than before, assuming you have made timely principal and interest payments. An interest rate swap would let you fix your debt service this time around, rather than float up to a prepaid cap strike. Since swap rates are also lower today than they were three years ago, you may be able to fix your debt service today at or near the same strike that you capped it at last time. Also, with two-way breakage on the swap, it can easily be an asset to you if rates were to rise and you were to prepay your loan and break the swap before maturity. Because the same collateral that underlies the loan agreement is typically required to underlie the swap agreement, you may be restricted to executing the swap with your lender, though, unless you have other forms of collateral available to you. Swapping out the remaining floating rate cash flows now could also give you the debt certainty you need to plan for the next phase of your business.
Do nothing. If your loan agreement does not require a hedge, then you may wish to consider going unhedged for the remaining life of your loan. The key questions you face are no different than before, though: What is your exposure to rising rates, what are the costs associated with hedging, and what is your view (if you have one) on the magnitude and timing of any future rise in rates? Without a new cap or a swap, your debt service on your floating rate loan will be unknown to you. If rates rose sharply, could you still meet all your loan covenants, and would you still be able to service your loan? Would rising rates simply be an annoyance to you, or could they lead to technical default, or even a liquidity crisis? Knowing these limits is key to understanding whether the “do-nothing” approach is even viable. Once you understand your limits, a scenario analysis will show you under which conditions the cap, swap, or unhedged approach would be the least expensive option. Finally, armed with your business limitations and cost projections, your view on interest rates would factor in to the final decision. While going unhedged is not a substitute for managing interest rate risk, it is a real option when exposures are truly minimal.
There’s no question that a sequel presents as many challenges as it does opportunities. When it comes to the hedging games, and executing your next transaction, no one helps you evaluate all your options better than Chatham. Give us a call!