March 28, 2011
It’s already springtime, which means your high school senior is less than six months away from (semi)independence. After much hard work, the fruits of your child’s labor are showing up in the mail in the form of acceptance letters to colleges throughout the land. You are proud, but concerned. How will your child choose the right school? Just then you observe your child carefully considering the pros and cons of each opportunity. As you stand there, worried, yet impressed by this unexpected display of maturity, you hear those words that would reassure any parent: “Don’t worry Mom and Dad, everything I ever learned about comparing alternative courses of action, I learned by watching you choose from among the various ways to hedge a future fixed rate financing.” What a smart kid!
With credit markets looking a little brighter and future financings now more certain, forward hedging is back. If your business has a future fixed rate financing on the horizon, you are likely weighing whether to hedge your interest rate risk with a treasury lock or with a forward starting swap. Both instruments can accomplish your objective of locking in the certainty of today’s low rate environment. But they do work differently, so understanding the differences will help you execute the right hedge for your scenario, and allow you to focus on the 100 other items you need to check off your financing to-do list.
A treasury lock provides a hedge against the change in price/rate of a specific tenured treasury security (on-the-run or to be issued), and is quoted as the forward rate expected for that security at the date of your financing event. The T-lock costs nothing upfront to enter into as the carrying cost is embedded in the price/rate, but will be cash settled when the contract expires. You can think of this as effectively shorting the treasury security and then buying it at the then-current price/rate to make settlement. Depending on your settlement method (price method or PV method), if the actual treasury rate is higher at settlement you will receive a payment roughly equivalent to the present value of the future cash flows on the difference between the actual rate and locked rate on the executed notional amount. If the actual treasury rate is lower, you will make a payment based on that difference.
A forward starting pay-fixed swap is a hedge against the change in both treasury rates and swap spreads, and is also quoted as a forward rate. Like the T-lock, the forward starting swap also costs nothing upfront to enter into, and would be cash settled on the date of your expected future financing. Also like the T-lock, your swap will either be an asset to you (swap rates have risen) or a liability to you (swap rates have fallen) at the time of your future financing event.
Both the T-lock and the forward starting swap provide a “good news / bad news” story, because higher interest rates mean that you would expect to receive a payment at hedge termination, but your actual fixed-rate funding would be higher; while lower rates mean you would expect to pay at termination, but your fixed-rate funding would be lower. In either scenario, the gain or loss on your hedge can be amortized over the life of your financing, and you have essentially locked in the economics of today’s rate environment in the process.
If your financing is delayed, the two instruments provide you with different outcomes. The T-lock would still be cash settled at the original maturity date of the hedge (typically the expected financing date), but you would be exposed to interest rate risk again unless you entered into another hedge. The forward starting swap, however, would simply become effective (i.e., start accruing interest, payable on each payment date) and would still be an effective hedge until the date of your actual funding, when it would be cash settled. If the financing is delayed long enough, though, it is possible that the hedge tenor becomes disconnected from the financing tenor and the hedge becomes less effective. Generally, if there is uncertainty around your expected future closing date, the forward starting swap will still provide you with the best flexibility to align settlement and funding dates.
Another difference between the two instruments is that the T-lock only hedges the treasury component of your future fixed rate financing, but as noted above the forward starting swap will hedge both the treasury component and the swap spread. The swap spread is traditionally thought of as a measure of interbank credit, and as such, is a factor in your own entity credit spread. Therefore, if swap spreads widen (i.e., as a result of worsening credit markets, your own borrowing spread is likely to widen as well, although there is no guarantee of this correlation. It could be worthwhile to confirm with your lender whether or not the spread is fixed or subject to change based on movements in swap spreads or general credit spreads.
Both T-locks and forward starting swaps are highly liquid instruments, but different forward periods could favor one instrument over the other. For shorter forward periods, the T-lock could provide the most efficient pricing, because it could be priced off and cash settled against the same on-the-run treasury. For longer periods, though, your counterparty would factor into its T-lock rate the “roll risk” or the cost of switching to the current on-the-run treasury each time a new treasury is issued (buying off-the-run to close out your position, shorting on-the-run), which could happen several times before your future financing date. A better approach for longer dated scenarios may be to use the forward starting swap, as it could be the most flexible and would eliminate roll risk.
Ultimately, your future fixed rate financing may not be complicated, but your views on interest rates, the certainty of your closing date, and the components of your rate that you want to hedge will drive your decision to use one instrument over the other. Chatham has helped numerous clients walk through their unique situations and determine the right structure, and would welcome the opportunity to help you too. Give us a call!