How to use blend and extend interest rate swaps to optimize your hedging program
Corporates | Kennett Square, PA
SummaryFollowing the steep drop in USD interest rates, many swaps became significant liabilities. Companies can consider a blend-and-extend strategy, which reduces their swap rate to lower cash interest expense and extends hedge coverage by several years.
- When interest rates plunged during the COVID-19 pandemic, companies saw their swaps become significant liabilities. At the same time, many face short-term cash needs due to the shifting business environment.
- If your company wants to reduce its swap rate to immediately lower cash interest expense and extend hedge coverage by multiple years, a blend-and-extend of your interest rate swaps presents an enticing strategy.
- While the upside of saving cash in this strategy is straightforward, the potential downsides are more nuanced. Review market intelligence, best practices, and appropriate accounting treatment to determine the right course of action.
What are the benefits of using blend-and-extend swaps?
Many corporate treasurers who hedged with interest rates swaps in the past few years now face a unique dilemma: following the precipitous drop in U.S. dollar (USD) interest rates during the onset of the COVID-19 pandemic in the United States, many of these swaps became significant liabilities, with pay-fixed rates often in the 2-3% range. Moreover, many companies face short-term cash needs as they cope with the shifting business environment of the pandemic. If your company wants to simultaneously reduce its swap rate to immediately lower cash interest expense and extend hedge coverage by multiple years, a blend-and-extend of your swaps presents an enticing strategy.
How does a blend-and-extend interest rate swap work?
The mechanics of an blend-and-extend work as follows:
- Your company chooses how far out you want to extend your hedge, suppose an extension to 2024 from an existing maturity date of 2022 (see example below). The current mid-market swap rate for a swap that is effective today and matures in 2024 is about 13 basis points*.
- Then, the current liability value of your existing trade is blended into this new swap such that the mark-to-market value of the new swap is the same as the old swap. A new swap rate is solved for that, which will be higher than an at-market swap, but lower than the current swap rate. Put differently, you are solving for a new swap rate that maintains the same liability value of the current swap but extends the maturity by several years.
Challenges and considerations for using blend-and-extend swaps
While the upside of saving cash in this strategy is straightforward, the potential downsides are more nuanced. Hedge accounting for such a transaction is more complex, requiring conversations with your hedge accounting advisor and auditors. Additionally, the product necessitates either using an incumbent bank counterparty or novating to a different bank, both of which can pose challenges if credit is limited or if pricing is less than transparent.
Other companies have found themselves in a position where cash balances are earning minimal return, so extinguishing existing swap liabilities with cash and entering into new at-market swaps has been a more optimal way to capitalize on the ultra-low rate environment.
In either case, advisors at Chatham Financial can partner with you in this decision process, providing access to market intelligence, best practices, and appropriate accounting treatment so you can determine the right course of action for your company.
About Chatham Financial corporate treasury advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Talk to a hedging expert
Complete the form below and one of our hedging specialists will contact you to assess if a blend-and-extend swap strategy is right for your company.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0316
Our featured insights
The hawks are back despite government default uncertainty
Many Federal Reserve members are signaling to the market that the fed funds terminal rate may need to be higher than prior FOMC projections suggested. They are also communicating that fed funds cuts will not occur until at least 2024. On the news, interest rates rallied despite economic...
- Post Date
- May 30, 2023
Intro to Hedge Accounting
Although complex, hedge accounting can be a very favorable accounting treatment for corporations considering hedging. During this session, our in-house hedge accounting experts will guide you through the basics of hedge accounting.
Intro to Hedging
Financial risk permeates through every corporation. Therefore, learning to identify, assess, and mitigate risk across various asset classes is crucial. In this session, explore how financial derivatives reduce risk and strengthen your hedging vocabulary.
Markets react to debt ceiling uncertainty, cooling home prices
U.S. markets ended last week on a turbulent note as Jerome Powell curbed rate expectations during a D.C. conference and debt ceiling talks abruptly halted. World leaders held the 49th G7 Summit as they shape potential international policy in relation to Russia and China. Median existing home...
- Post Date
- May 22, 2023
Interest rate caps vs. swaps: weighing the alternatives
When deciding between interest rate caps and swaps, you typically need to consider the inherent benefits of each instrument within the context of the current interest rate environment. In this article, we’ll review the fundamentals of caps and swaps and consider how market factors can affect...
Inflation making its way down, markets remain opposed to Fed on future of rates
Inflation reached two-year lows in April, encouraging markets to maintain their stance that rate cuts are coming soon. Meanwhile, Fed officials have kept their options open on the path forward for rates for the rest of the year.
- Post Date
- May 15, 2023
Fed hikes rates while labor market surprises
On Wednesday, members of the FOMC unanimously raised the federal funds rate by 25 basis points to a target range of 5.00% - 5.25%. The labor market grabbed headlines with higher-than expected nonfarm and private payrolls, while recession fears weigh heavily on oil prices.
- Post Date
- May 8, 2023
Five new LIBOR questions your organization must answer before June 30
The June 30, 2023, LIBOR cessation date is rapidly approaching. While some organizations proactively completed the transition, many others must still address these five key questions about their debt and derivatives.
- Post Date
- May 3, 2023