Published December 2004

Tools to help you
weather interest-rate cycles

By Evelyn Lane
Guest Columnist

Over the past few years, many businesses have enjoyed the benefit of historically low short-term interest rates, in some cases their lowest levels since the 1950s. As businesses typically fund inventory and other short-term assets with short-term floating rate debt, the lower cost of acquiring and paying down this debt has helped these companies weather the challenges they have faced since the recession in 2001.

For some long-term borrowers, however, today’s short-term rates when compared against long-term rates may present wallet-wrenching decisions. As a long-term borrower, should you fund your loan with the low, floating short-term rates available in today’s market? Or, should you acquire a fixed rate and pay the “premium,” or spread over current short-term rates, which, over the past couple years, have been as high as 350 basis points over short-term rates.

In choosing a short-term floating rate, the borrower takes on the risk that rates will rise. This is not a gamble many businesses, long-term borrowers or even economists want to take today, especially in light of the Federal Reserve’s stated intention to raise short-term rates. To complicate matters, no one knows how high or how fast the Federal Reserve will raise rates.

As a result, most companies continue to obtain fixed-rate lending to match the term of their asset with the term of their debt — a well-proven financing strategy. Companies need to stay focused on the long term, and the decision to apply a fixed rate on long-term debt remains more prudent than ever — especially given that short- and long-term rates remain near 40-year lows.

Yet there are alternative measures your business can take to weather shifts in the cost of borrowing. Previously, borrowers could change their interest rates and debt maturities only by relatively inflexible methods such as pre-paying — often with a penalty — and issuing new debt. With the advent of interest-rate “caps,” “collars” and “swaps,” business borrowers can respond effectively to changing interest-rate market conditions.

Here’s how they can work for you: Your banker should first analyze your company’s needs and then show how the different hedge instruments will perform under various interest-rate scenarios.

Your banker will work with risk management specialists to identify your interest-rate risk and then help you decide what level of risk is acceptable and select an appropriate hedge strategy. Examples are noted below.

n Floating-rate caps — Caps provide a ceiling against a significant increase in short-term rates while allowing you to enjoy the full benefit from lower rates.

For example, on a five-year, floating-rate term loan priced at a one-month LIBOR rate of 2 percent plus 3.25 percent credit spread for a current all-in cost of 5.25 percent, you could purchase a five-year cap of 6.75 percent on the LIBOR rate. That would guarantee that your all-in cost would never be above 10 percent (maximum LIBOR rate plus the credit spread).

What’s great about a cap is you have two ways to purchase them. The first option is to purchase with a premium paid in advance (as is the case with most insurance policies). The second option, and one increasingly preferred by many firms, is to pay the premium over the duration of the cap. In this case, you pay for the protection over time, and thus it is called a “pay-over-time cap.” In either case, you gain the benefit from low rates but have protection against excessively high rates. What could be better in today’s environment?

n Floating-rate collars — Collars provide a rate ceiling and a floor, thereby limiting interest rate movement within a range.

For example, on the loan cited above, a collar could be purchased that would maintain your all-in rate between 6 percent and 10 percent. The premium for this collar would be less than for the cap because your benefit from lower rates would be limited. In many instances, such structures can be achieved without paying an up-front premium.

n Swaps — An interest-rate swap enables a borrower to reduce or eliminate interest-rate risk by synthetically “fixing” floating-rate debt. In a transaction separate from the original loan, the client enters into a contract with a lender to exchange cash flows (the client receives the floating-rate index, such as one-month LIBOR, and pays a market-determined fixed rate). As a result, the borrower’s all-in cost stays the same for the duration of the swap, whether interest rates rise or fall.

Using the five-year LIBOR-based term loan cited above as an example, with a LIBOR rate of 2 percent, this is how the swap would work:

1. Original floating-rate loan: The borrower pays LIBOR (2 percent) plus the credit spread (3.25 percent). The all-in rate is 5.25 percent, which will fluctuate as market conditions change.

2. LIBOR-based interest-rate swap: The borrower receives LIBOR (2 percent) from the lender and pays a fixed rate, in this case 5 percent.

3. Combine the two: When the loan and the swap are combined, the client’s all-in rate is 8.25 percent (the credit spread of 3.25 percent plus the fixed swap rate of 5 percent).

What if LIBOR rises to 5.5 percent? The client’s all-in-rate remains at 8.25 percent. Had there been no swap, the figure would be 8.75 percent (LIBOR of 5.5 percent plus credit spread of 3.25 percent).

What if LIBOR is 4.25 percent or below? The client’s all-in-rate remains at 8.25 percent. Had there been no swap, the figure would be LIBOR plus the credit spread (7.75 percent).

In summary, swaps, pay-over-time caps and most collars give you protection with no up-front fees. Swaps provide an effective fixed rate and a structure that can be superior to traditional fixed-rate loans.

All three products offer other benefits, such as financing flexibility, the potential to transfer your interest-rate structures to other loans and even the ability to set a rate before your loan is funded. Since caps, collars and swaps are applied to underlying floating-rate loans, you avoid early loan pre-payment penalties.

These products have their own market value, and you may realize a gain if they are terminated before maturity. Conversely, depending on your rate and current market rates, they may require you to pay a fee if terminated early. However, these fees can typically be lower than the pre-payment penalties associated with traditional fixed-rate loans.

Are caps, collars and swaps right for your business? That’s a question only you can answer. But armed with information from your banker and your bank’s financing experts, you can find the answer that’s in your best interest.

Evelyn Lane is a business banking manager for Wells Fargo in northern Washington. To reach her, call 425-252-1620 or send e-mail to laneevel@wellsfargo.com.

Back to the top/December 2004 Main Menu