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To Swap or not to Swap; What to Consider When Converting Variable Rate Debt to a Fixed Rate.
Many companies have been enjoying slow sales growth and strong cash earnings since 2011 as the US economy continues to recover from the recession. Even better is that while earnings have improved, companies have continued to see some of the lowest costs of capital in US history as they have taken on new debt or re-financed existing debt over the past two years. A large portion of this debt was issued with variable interest rates with three to seven year maturities, with interest rates not moving much since the valley of the recession. However, all good things must come to an end and the question is when and how fast will commercial interest rates creep upward. A slow and steady increase will slow down the recovery while a rapid increase could send the economy into a tail-spin. Holders of variable rate debt have to ask the question if they should be hedging future rate hikes with fixed rate swap’s to protect cash flow and extend these historically low interest rates.
A prime example of a rate jump impact is seen when reviewing yield curves from June of 2013 and from the middle of August through September of 2013. Treasuries jumped up 10 to 20 basis points during these periods, and swap yield curves jumped more than one percent from May of this year through mid September, and then calmed back down at the beginning of October. Almost instantly, it looked like the cost to service variable rate debt was going to increase significantly within the next three to five years. It seems hard to believe that rates will increase any time soon given the uncertainty in the U.S. economic recovery, with politicians willing to shut down the federal government while bickering over the Affordable Care Act and the debt ceiling, and unemployment rates continuing to lag the recovery. Not to mention, we all know of someone who was burned with fixed rate swap’s being under water during the recession, and they may still be paying on the mark to market exposure today. None of this should be an excuse to not assess variable rate interest risk, and develop a strategy to hedge the risks through fixed rate swap’s.
Identifying the cash flow impact of increases in interest rates on variable rate debt is easy, but outlining the solution to hedge rate increases can be difficult as swap’s are complex financial instruments. A good hedging strategy should address the amount of variable rate debt to be hedged on a fixed rate swap, the length of the hedge, and the ceiling for a variable rate to be converted to a fixed rate swap. It is not recommended to hedge the entire amount of variable rate debt under a swap for various reasons; however, one could consider a declining balance swap to cover a constant percentage of variable rate debt as the debt is paid down. The length of the swap should not exceed the maturity of the variable rate debt, nor does the term need to cover through the debt maturity date. Additionally, one may consider a forward looking swap in which a swap is locked today, interest is variable for a set period (e.g., one year), and then the fixed rate commences on a future date through the end of the swap term. Lastly, in considering a swap hedging strategy, a line needs to be drawn in the sand to determine how high one is willing to let interest rates increase before a fixed rate swap is executed. Each one of these decisions should be made in conjunction with a company’s risk profile to mitigate the risks associated with these complex financial instruments.
Amnesia has set into the US economy with an extended period of low interest rates; however, the first sustainable rate increase will feel like running into a brick wall. When rates skyrocket in the future, amnesia will set in again. Only this time, everyone will forget about the horror stories of company balance sheets tanking during the recession as they recognized large liabilities associated with high priced swap’s executed pre-recession. The best advice is to proactively develop a hedging strategy while rates are still low and execute the hedging strategy to avoid surprises and dead ends.