Lou Fender, Sr. Vice President & Market Manager, Southwest Ohio, WesBanco
Most of us are very familiar with the quote “a picture is worth a thousand words!” The phrase is widely attributed to Frederick Barnard who published a piece on the effectiveness of graphics in advertising back in 1921. A related expression I like to quote, however, is “an example is worth a thousand pictures”.
Are you in the growing camp of business leaders (including economists, Federal Reserve Chair and Board members) who believe we are in for a period of rising interest rates? Despite recent estimates that long-term rates may not increase at the level previously thought, the Federal Reserve expects to deliver two more rate hikes this year. If you are in that group of believers then an “example” of how a privately held business can protect itself in this environment could make sense for your specific application.
If your business has a future fixed rate financing on the horizon (i.e.: constructing a new facility for expansion or relocation, purchase of new equipment, or an acquisition) you are likely weighing whether to protect yourself from interest rate risk. However, you would like to “float” or remain variable due to the current lower end of the yield curve or not being fully borrowed completely on the future project until conclusion.
You can achieve this protection by using what is known as a forward starting SWAP (pay-fixed). An interest rate SWAP is a binding agreement between counterparties to exchange periodic interest payments on some predetermined dollar principal (usually at least $1 million notional amount). The forward swap is a hedge (think of it as an insurance policy) against the change in both treasury rates and SWAP spreads and is quoted as a forward rate. The forward starting costs nothing up front to enter into, and the cost of the financing is built into your future rate. Also, because the yield curve is relatively flat the premium spread (the increased number of basis points for fixing at a future date versus fixing with certainty today) for the forward SWAP is thinner than historical forward starting swap spreads.
Let’s do an illustration. Say you are building a $5 million building which will be occupied in one year. We will further assume that your bank’s fixed rate quote via an interest rate SWAP today (10 year term and 20 year amortization) would be 4.86 percent. However, your variable interest rate is 3.627 percent, and recall that not all of your $4 million (80 percent of the building cost) loan amount will be outstanding on day one. Proceeds of the real estate loan will be drawn down over the next 12 months as work in the construction process is completed and affidavits for payments are submitted.
With the use of the forward starting SWAP, given today’s interest rate environment, this could add 13 basis points to the ultimate fixed rate selected for a rate of 4.99 percent. By utilizing the forward starting SWAP you would know with certainty that one year from today, regardless of how much interest rates move up over the construction phase, your rate is fixed for the ten year term. Furthermore, you can continue to borrow at their LIBOR based rate of 3.627 percent (or their relative spread should LIBOR move up as projected) initially, thereby keeping interest costs to a minimum.
Understand that your SWAP will either be an asset to you (SWAPS rates have risen), or a liability to you (SWAP rates have fallen) at the time of your future financing event. If for any reason your project is delayed, your fixed rate would simply become an effective hedge until the date of your actual funding completion date. Generally, though if there is great 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.
Ultimately, your future fixed rate financing may not be complicated, but your views on interest rates should drive your decision to use this method. Used in this example a company can protect themselves in a rising interest rate environment as well as retain the benefits of remaining variable for the contracted period of time.