Interest rate swaps Featured

8:00pm EDT October 25, 2006
An interest rate swap is a financial contract involving an exchange of interest rate payments between an entity and its bank. Under a typical agreement, a company makes payments to a financial institution based on a fixed rate of interest while agreeing to receive payments based on a floating-rate index such as LIBOR or the prime rate.

Interest rate swaps are ideal for protecting against a rise in interest rates and can reduce the prepayment penalty associated with the termination of traditional fixed-rate debt. Also, they can be tailored to match the borrowing needs of any company.

“Interest rate swaps are very flexible and can be structured to match any portion of the underlying floating rate debt that a company wishes to fix,” points out Everett Orrick, senior vice president and regional manager at Comerica Bank.

Smart Business spoke with Orrick about how a company can benefit from floating rate loans with a swap, how fluctuating interest rates affect this type of vehicle and what types of documents are required.

How do floating-rate loans and traditional fixed-rate loans differ?
A floating-rate loan with a swap differs from a traditional fixed-rate loan in that there are essentially two payments between a customer and the bank to create the equivalent of a fixed-rate of interest. An interest rate swap is a separate financial contract which, when combined with a floating-rate loan, synthetically fixes the underlying floating-rate index through the exchange of fixed versus floating interest payments.

How can a company benefit from using a floating-rate loan with a swap?
The beauty of an interest rate swap is that it can be structured to meet the client’s needs in any interest rate environment. Also, if a company ever has to terminate its swap, the termination costs are typically far less than the traditional fixed rate loan. There are two other interest-rate risk-management tools that can be used as well. Interest rate caps essentially limit how high the interest rate can go on a debt; they don’t specifically fix the rate, but they limit the upside. Also, there is a product called interest rate collars which create a range of rates around which the floating-rate debt can float. It has a cap on the upside and a floor on the downside.

How do cash flows of a fixed-rate loan and floating-rate loan with an interest rate swap compare?
They are remarkably similar. The difference is that with a swap product there are two payments from the customer to the bank compared to one payment with a fixed-rate product. Essentially, the interest cash flows of a fixed-rate loan can be mimicked through the use of a floating-rate loan with an interest rate swap. Various amortization structures found in traditional fixed-rate financing can be modeled using an interest rate swap.

What happens to a floating-rate loan with a swap if interest rates move lower?
If interest rates decline, the client’s rate does not change, there is just a change in interest payments between the floating-rate loan and the interest rate swap. The interest rate swap only hedges the underlying index on the loan, not the credit spread.

In terms of risks to a client, if rates move lower and they wish to terminate the swap transaction there may be a cost to unwind it which would be referred to as a market value loss. However, the market value loss is going to be much less than the prepayment premium on a traditional fixed-rate note. As long as the loan is outstanding, the net effect of a swap and fixed-rate loan are the same. Regardless of which direction rates move, the customer locks in a fixed rate of interest. The benefits come into play when a customer has to unwind his or her credit facility for some reason. This could be because he or she sells a property or comes into a large amount of cash and no longer wishes to have debt. Under this scenario, the swap becomes a much better tool than a fixed-rate loan.

What if interest rates rise?
If interest rates rise and the client wishes to terminate the swap contract, it is likely that the interest rate swap would have a market value gain and the client may get paid to terminate the transaction. Borrowers never get paid premiums to terminate-fixed rate loans.

EVERETT ORRICK is senior vice president and regional manager at Comerica Bank. Reach him at (714) 435-3998 or eorrick@comerica.com.