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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

  • Expectations for multiple rate hikes over the next year have introduced new considerations to the caps versus swaps debate.
  • While many of the pros and cons apply in any macroeconomic environment, factors like upfront cost and disaster protection have grown more impactful as the forward curve has risen.
  • The shape of the current forward curve has lent some credibility to using caps for disaster protection, but swaps are still the preferred instrument for most large corporates.

(Updated February, 28 2022)

As the forward curve has steepened over the past year, many companies 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 the second quarter of 2021, the forward curve has steepened significantly for shorter tenors, as persistent high inflation has accelerated the timeline for rate hikes from the Federal Reserve. Over that time, Powell and other Fed officials have become gradually more hawkish, especially as the labor market has gained strength. With that said, macroeconomic concerns resulting from the recent spike in oil prices and ongoing conflict in Ukraine will likely introduce some dovish sentiment at the Fed, for fear that too many rate hikes could induce a recessionary environment.

Chart showing historic forward curve for 1 mo. USD Libor

Disaster protection

Rapid steepening in the near-term portion of the forward curve over the last few quarters has made it impossible to access the extremely low swap rates that companies saw earlier in the pandemic. As a result, some corporates have become less focused on locking in a swap rate based on the current forward curve, and more focused on protecting against disaster scenarios (e.g., a significant upward shift in the forward curve).

The thinking here is that the market has already priced in multiple rate hikes, which has made swap rates less appealing in the short term. At the same time, the far-end of the forward curve has remained fairly rangebound, meaning that caps with strikes over 2.0% may still have appealing premiums. We often provide custom indications and insights on cap structures to companies interested in exploring whether premiums are within their budgets. For a quick look at current cap prices, see our free online calculator here.

The role of volatility

While volatility has remained consistently below pandemic peaks over the past year, even short-term increases can drive up cap premium costs and make interest rate swaps the more enticing instrument. After a momentary spike in December, volatility was trending downwards, but that trend has reversed over the last month as inflation and other macroeconomic factors have introduced more uncertainty to markets. With that said, volatility for a 5-year OTM cap struck at 2.5% is still well below its 12-month high.

Credit vs. cash

Another key factor in the caps vs. swaps debate is cash availability. For companies worried about the prospect of rising rates, 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 may only be a popular choice among companies that lack adequate creditworthiness to pursue interest rate swaps.

The relevance of floors

When rates were at historic lows, companies with floors on their underlying credit agreements often needed to embed floors in their swaps to qualify for hedge accounting. Because floors were so expensive in those conditions, the all-in swap rates companies could achieve became much less attractive (e.g., the fixed rate on a swap with an embedded 1% floor will always be above 1%).

Now that rates are expected to rise rapidly to the 1.5-2.0% range, floors struck below those levels are no longer expected to have significant value beyond this year. In some cases, this may make it unnecessary for companies to embed floors in their interest rate swaps, since they will not have as material an impact on mark-to-market values each period. We often advise companies on whether embedding floors is necessary by modeling potential rate movements and the resulting impact to hedge accounting effectiveness.

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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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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