Deferred Premium Caps

A cap is one of the simplest ways to hedge a floating rate loan. It sets a ceiling on SOFR, retains the ability to float lower, and has no prepayment penalty. The downside is the upfront premium, which is due within two business days of trade (T+2).

Given the constant chatter of potential hikes, many groups are reevaluating their positions and considering additional hedges. If you’re in that camp, a deferred premium cap is an alternative to consider, as it puts a ceiling on your rate without the need to call capital or use cash reserves.

With a deferred premium cap, you get the exact same protection, but in lieu of one large payment upfront, you make a fixed monthly payment over the life of the hedge.

How it works

The structure is effectively a combination of a cap and swap. You buy the cap you want, but in lieu of paying the premium T+2, you agree to a fixed monthly payment over the term.

One major consideration before continuing: since the hedge is a combination of a cap and swap, the underlying lender needs to be a bank that can offer swaps, or you'll need to be able to trade under a fund level entity with a bank that can.

Here’s what happens each month:

• When SOFR is above your strike, you receive the cap payout, just like a vanilla cap.
• When SOFR is below your strike, there’s no payout, and you get the benefit of floating lower.
• Either way, you make the fixed monthly deferral payment too. What settles each month is the difference between the cap payout and that deferral payment.

Net result – cap protection, you still float lower if rates fall, and no upfront premium.

Assume you wanted to purchase a $100mm 1 year 4.00% strike cap.

• The upfront cost of that hedge is around $255k today.
• Rather than paying the $255k premium upfront, you’d execute a premium deferral and make a fixed payment of ~$22.8k/mo., or about 0.27%.
• On a present value basis, $22.8k/mo. equals roughly $267k.

The difference between the upfront premium and NPV of the deferral payments is attributed to the deferral or “financing” charge. The deferral charge can vary depending on the bank, borrower, hedge structure, etc.

What do the cashflows look like?

If you’re a visual person, here are the month-by-month cashflows for both structures using the current forward curve. The cap payout is identical in each – the only difference is how you pay the premium.

Traditional Cap

Deferred Premium Cap

When does this make sense?

Some example scenarios include:

• You want or need additional protection and would rather not call capital or dip into reserves to pay an upfront premium.

• You want or need additional protection and would like to retain floating exposure.

• The underlying lender is a bank, or you have the ability to trade at the fund level.

• The deferral charge is lower than your cost of capital.
  
  

What if I want out early?

If you unwind before maturity, the breakage is simply (i) cap value, less (ii) the PV of the remaining deferral payments.

The deferral liability is just the remaining scheduled payments – it doesn’t move against you when rates fall the way a swap’s MtM would. If rates drop, your deferral liability is materially unchanged and only the value of the cap declines.

In other words, the downside on an early exit is far more limited than a swap or collar.

Anything else I should know?

• The deferral charge isn’t necessarily set by the market. In scenarios when there are multiple potential counterparties, it makes sense to shop the upfront and all in costs to ensure the best execution.

• The same deferral mechanic can be applied to a corridor to bring the cost down even further. More on this in a follow up resource.

A trade idea

Let’s do a quick comparison of a 1 year deferred premium cap to a swap.

• A 1 year swap would have a 4.08% rate

• • Your rate jumps from spot SOFR (3.67%) to 4.08%, and you have a guaranteed interest expense of $4.14mm.

• A 1 year 4.00% cap would have a deferral rate of 0.27%

  • Day one, you’re paying 3.94% (SOFR + 0.27%) and have a max potential rate of 4.27%.

  • If the Fed doesn’t hike at all over the next year, the premium deferred cap comes out ahead by ~$138k (0.14%).

  • If the Fed hikes in line with expectations, you pay ~$129k more (0.13%).

In other words, retain floating exposure, and if the market’s wrong about hikes, come out ahead by 0.14% or more.If the market’s right about hikes, pay an additional 0.13%. If you needed a 1 year hedge and both options were on the table, which would you pick?

Next week, we’ll look at how a premium deferral could fit into a fund level hedging strategy.

Interested in discussing deferred premium caps further or weighing other potential strategies for one of your upcoming financings? Give us a call at 704-887-9880, email us at pensfordteam@pensford.com, or respond directly to this.

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