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Interest rate caps vs. swaps: corporates weigh the alternatives

  • Scott Balta headshot

    Authors

    Scott Balta

    Associate

    Corporates | Kennett Square, PA

Summary

Evolving market conditions over the past year have led many companies to revisit the caps vs. swaps debate. While caps initially gained traction for their upside potential, swaps remain the preferred instrument for corporates seeking to mitigate interest rate risk.

Key takeaways

  • The continued low interest rate environment has introduced new considerations to the caps vs. swaps debate.
  • While many of the pros and cons apply in any macroeconomic environment, factors like upfront cost and the relevance of floors have grown more impactful since the onset of the pandemic.
  • Though the prospect of prolonged low rates has made caps appealing for their upside potential, swaps are still the preferred instrument for most large corporates.

Since the initial rates decline in March 2020, many companies have sought to increase their fixed-rate debt ratios by employing interest rate swaps or caps. While caps have gained some traction recently, primarily as a way to achieve disaster protection while preserving upside, swaps are still the preferred instrument for corporates looking to minimize interest rate risk.

Market update

Since hitting bottom in early August 2020, the forward curve has entered a gradual steepening trend, driven by vaccine distribution and hopes for a large stimulus package under the now Democrat-controlled legislature. While the prospect of a return to normalcy has introduced risk-on sentiment to markets, the cumulative economic cost of the pandemic is still weighing somewhat on growth forecasts for 2021.

Disaster protection

The presence of long-term low rates has led more treasurers to consider purchasing high-strike caps for disaster protection. Especially in mid-to-late 2020, caps in the 1.5-2.5% strike range were at historically low premiums, while still offering protection against an extreme upward movement in rates. Since then, the forward curve has steepened significantly, and premiums have increased, making it more expensive to achieve protection using caps, even for “worst-case” scenarios.

The role of volatility

Despite the low rate environment, heightened volatility has been quietly keeping upward pressure on premiums since Q1 of last year. After the initial spike in March, ongoing economic and political turmoil prevented volatility from dropping to pre-pandemic levels, even as equities and rates began to climb. With the forward curve steepening in recent months, the potential for low-rate, low-volatility conditions may be behind us.

Credit vs. cash

One key factor in the caps vs. swaps debate is cash availability. For companies negatively impacted by the pandemic, or otherwise interested in preserving liquidity, paying out unnecessary premiums may be a decisive factor, especially when swaps can provide similar protection at no upfront cost. If short-term cash preservation is a priority, caps lose much of their appeal, and for companies with sufficient creditworthiness, swaps may offer a better choice.

The relevance of floors

In the face of near-zero rates, companies with floors on their underlying credit agreements often need to embed floors in their swaps to qualify for hedge accounting. Because floors are so expensive in these conditions, the all-in swap rates companies can achieve become much less attractive (e.g., the fixed rate on a swap with an embedded 1% floor will always be above 1%).

As a result, some corporates have explored using caps to mitigate risk without paying for embedded floors. But in some ways, this distinction is only psychological. If you have a 1% floor on your debt, you won’t be able to access upside below that level, regardless of whether you swap or cap. And if you can lock in a swap (with an embedded floor) at a fixed rate just above 1%, the window for cap upside participation is actually very limited, because your debt service has already reached its lower bound.

Of course, determining the appropriate financial instrument depends on your organization’s specific situation and objectives. Schedule a conversation with a Chatham advisor for support in achieving the most effective strategy and pricing.

Chatham Financial corporate treasury advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s 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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About the author


Disclaimers

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.

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