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Receive-fixed interest rate swaps: what corporates need to know

  • kevin jones headshot

    Authors

    Kevin Jones

    Director
    Treasury Advisory

    Corporates | Kennett Square, PA

  • brittany jervis headshot

    Authors

    Brittany Jervis

    Director
    Accounting Advisory

    Corporates | Kennett Square, PA

Summary

Corporate treasurers assessing their debt capital structure perceive tension in today’s environment: on one hand exists the potential for low short-term rates to last for years; on the other hand, is the specter of Fed rate hikes and likely inflation. Many companies are evaluating receive-fixed interest rate swaps as part of their debt capital structure. This derivative instrument has several use cases, benefits, and potential drawbacks worth considering through an economic and accounting lens.

Trade dynamics and use cases

In terms of use cases, many companies with predominately fixed-rate debt are seeking a mechanism to increase exposure to floating rates. For some companies, executing such a derivative is a far quicker (and cheaper) mechanism to introduce floating-rate debt into the capital structure, albeit synthetically. In other cases, companies have large cash balances that are earning minimally in the low-rate environment; receive-fixed swaps allow these companies to benefit from the low rate environment, offsetting the minimal benefit offered by their cash balances. Finally, other companies currently have a short-term cash need; as illustrated in the chart below, any company executing a receive-fixed swap today will immediately receive a cash benefit or reduction in interest expense.

Mechanically, in a receive-fixed interest rate swap, the company agrees to receive a defined fixed rate over a period of time from their hedge counterparty. In exchange, the company will pay floating LIBOR, plus a spread determined at the time of trade. During periods where the LIBOR forward curve is upward sloping (currently the case as of this writing), the hedging company will be a net receiver of cash. If rates were to follow the curve over the life of the trade, the company would then be a net payer at the end of the swap. This schematic is illustrated in the above chart.

Hedge accounting treatment

As with any derivative transaction, it is important to understand the underlying accounting and how the transaction will impact the financial statements. When a company looks to convert fixed-rate debt to floating-rate debt for any of the use cases discussed above, we refer to this as a fair value hedge. Unlike cash flow hedge accounting, which results in a special election to defer derivative gains and losses on the balance sheet, hedge accounting for a fair value hedge results in special accounting for the underlying being hedged. As the hedge changes in value, gains and losses are recognized in current earnings. By electing and qualifying for fair value hedge accounting, the changes in value (attributable to the risk being hedged) associated with the hedged debt are also recognized in current earnings, within the same income statement line item.

Similar to a cash flow hedge, to apply and qualify for fair value hedge accounting, a company must complete hedge documentation contemporaneously with entering into the derivative transaction and assess effectiveness to ensure the derivative is highly effective at offsetting the hedged risk. Because both gains and losses on the derivative and hedged debt flow through to current earnings, it is critical at inception to properly align the hedge and hedged item to avoid unforeseen, visible ineffectiveness.

Other considerations

There are further areas of understanding to be explored for this product, including trade execution dynamics, credit pricing, optimal trade structure within the capital structure, and more. Like any interest rate derivative, ISDA and Dodd-Frank regulatory compliance items need to be in place before executing any trade. Finally, the landscape of the LIBOR transition continues to impact corporate decisions in this space. Reach out to your Chatham hedging advisor or complete the form below to connect with our team to discuss further.

Chatham corporate treasury advisory and hedge accounting

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of solutions 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 authors

  • Kevin Jones

    Director
    Treasury Advisory

    Corporates | Kennett Square, PA

    Kevin Jones serves Chatham’s corporate clients in interest rate and foreign currency hedging advisory. Kevin’s expertise spans risk quantification and analysis, hedging strategy development, market dynamics, and trade execution.
  • Brittany Jervis

    Director
    Accounting Advisory

    Corporates | Kennett Square, PA

    Brittany leads the Accounting Advisory team for Chatham’s Corporates sector. Prior to joining Chatham, Brittany spent time at Deloitte, and graduated from Pennsylvania State University.

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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