Hedging Falling Rates

As rate expectations change, so should your hedging strategy. Borrowers can face exposure to falling rates just like they can with rising rates. Below, we’ll share a few popular solutions for three common pain points in a falling rate environment.

For a solution tailored to your deal, reach out to the experts at PensfordTeam@Pensford.com or (704) 887-9880. We’d love to help you find ways to maximize taking advantage of falling rates.

1. Floating Rates are Headed Lower

Floors – If you’re unable to negotiate out your loan floor or want to buy a rate cap below your loan floor, you can purchase a floor that pays you as rates fall. This can be structured to offset the floor on the loan entirely or bring the effective minimum rate down to a lower level. Think rate cap but upside-down.

Floors can also be used to synthetically convert a fixed rate loan to a floating with an imbedded rate ceiling. If you’re traditionally a floating rate borrower but fixed rate terms look more attractive right now, pairing the fixed option with a floor can be a viable alternative.

Swaps – For borrowers with bank debt, these can be used to convert fixed to floating for no upfront cost. The tradeoff is the potential for a prepayment penalty in the future if exiting prior to swap maturity.

2. Fixed Rates are Headed Lower

Swaptions – These are essentially call options on fixed rates. They can be used to hedge both rising and falling fixed rates, and are highly effective for hedging against yield maintenance, make-whole, and defeasance. Swaptions are most effective when the timing of the sale or refi is known. They can be purchased for an upfront premium and are settled in cash at closing.

Floors – If the timing of the sale or refi is unknown or broad, or if you’re looking to generally hedge prepayments that are indeterminate, floors can be a more efficient way to hedge future penalties. In exchange for the added flexibility, floors cost slightly more than swaptions. However, they also have the potential to payout on a monthly basis.

3. Rates Could Fall Less than Expected

Step-Down Strikes – Caps and swaps can both be structured with a strike/rate that changes over time. By raising the strike on the front end and lowering the strike on the tail end, the structure becomes more curve efficient and more closely mirrors current rate expectations. For a cap, this can help mitigate some of the volatility premium. For a swap, this also reduces some of the prepayment risk on the tail end.

Forward Swaps – Because the forward curve is downward sloping, locking in a forward starting swap lowers the rate. This can also help mitigate the prepayment risk. A more comprehensive hedging strategy might include pairing a short-term cap with a forward starting swap.