How to use extend and blend interest rate swaps to optimize your hedging program
Corporates | Kennett Square, PA
Following the steep drop in USD interest rates, many swaps became significant liabilities. Companies can consider an extend-and-blend 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, an extend-and-blend 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 extend-and-blend strategies?
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, an extend-and-blend of your swaps presents an enticing strategy.
How does an extend-and-blend interest rate swap work?
The mechanics of an extend-and-blend 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 extend-and-blend 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.
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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
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