Over the past four years, swap rates have trended lower than Treasurys. Take 5 year rates for example – the spread between the two indices has widened roughly 0.18%.
What does this mean for you? Assume you’re locking a 5 year fixed rate with a 2.00% spread.
- If locking off Treasurys – 3.98% 5 year Treasury + 2.00% spread = 5.98%
- If locking a bank swap – 3.78% 5 year swap + 2.00% spread = 5.78%
We often hear groups say they have a firm “no swaps” policy due to a trade that went bad in one of the previous cycles. But unless you swear off ALL fixed debt, “swap” shouldn’t necessarily be a dirty word.
With (what seems like) an uptick in bank lending activity, we thought it’d be a good time to revisit some benefits of swapping.
Swap rates are below Treasurys
You’ve already established that the 5 year swap rate is 0.20% less than the Treasury based rate. Here’s a table comparing Treasurys to swap rates (including assumed credit charges) across a range of tenors. Note, bank swap rates assume monthly payments.
You can create your own open period
A typical floating rate bank deal has no prepayment penalty, and all swaps mature at par (meaning no penalty either). If your lender is allowing a hedge shorter than the initial loan term, then you can effectively create your own open window, with no spread adder to boot!
Assume a 5 year $50mm I/O loan at SOFR + 2.00%, with plans to prepay at the end of year 3. You could lock a 5 year swap at 5.78% all in and deal with the breakage at the end of year 3.
Here’s a sample of what the breakage, expressed as a percentage of the loan balance, could look like under different rate environments. Note, negative figures represent a liability to the borrower.
Here’s how to interpret the table:
- If rates follow current expectations, the 2 year swap rate 3 years from now would be 3.63%. The breakage (due by borrower) would be around 0.31% of the loan balance.
- If rates are 2.00% above market expectations (implying a 5.63% 2 year rate), the swap would have a positive value (received by the borrower) of 3.76% of the loan balance.
- If rates are 2.00% below market expectations (implying a 1.63% 2 year rate), the swap would have a breakage of around 4.37% of the loan balance.
Alternatively, a 3 year swap could be locked in around 5.76% all in. Here’s a sample of what the breakage would look like at the end of year 3:
0.00% – all swaps mature at par!
Another way to frame this is eliminating your financing risk for as long as possible, while matching your interest rate risk to your expected hold term. What happens if you don’t sell/refinance as planned? You execute a replacement hedge.
Ability to use hybrid hedging strategies
Want to fix some portion of the debt but retain floating exposure? Maybe the desire is driven by the belief that rates are going to fall, or perhaps you just want to reduce the initial outlay (cap cost). You don’t necessarily have to swap 100% of the loan balance.
We recently wrote about hybrid hedging strategies here.
Can buy the rate down as much as desired
Where some lenders only allow a limited rate buydown, or others won’t permit it at all, buying down a swap rate is simple. The cost of doing so is a factor of (i) the present value of each basis point on the swap aka PV01, and (ii) the number bps the rate is being bought down.
Building off our $50mm 5 year example, the PV01 is ~$23k. Therefore, if the target rate was 5.50% all in, the cost to buy it down 28 bps would be $644k ($23k * 28).
Side note – buying down a swap rate reduces the future potential prepayment penalty (compared to the market rate).
If the swap breakage is bad, the defeasance premium will be worse
Below, I’ve included the same table above from our 5 year swap that’s terminated at the end of year 3.
Next, I’ve included a table assuming the loan is locked off Treasurys (at 5.98%) and is subject to defeasance.
As seen above, the defeasance premiums are considerably more than the swap breakages under the various rate environments. This is because a swap is only against the borrower by the amount of the credit charge on day one, whereas a defeasance or yield maintenance is against borrower by the amount of the spread.
Furthermore, we can help terminate a swap over a 5 minute phone call but a standard defeasance process can take 30+ days and includes $50k+ of transaction costs.
What about yield maintenance
Defeasance and yield maintenance penalties are relatively similar, but yield maintenance provisions often include a 1% minimum, whereas a defeasance can be in favor of the borrower (more on that here). If rates are above market expectation in the future, the yield maintenance provision could end up being more costly.
We’ve seen this countless times over the past couple years. Below, we’ve included a sensitivity table assuming the loan is locked off Treasurys (at 5.98%) but is subject to yield maintenance, with a 1.00% minimum.
And declining flat percent
A discussion about prepayment penalties wouldn’t be complete without mentioning declining flat %. This option seems to be common on balance sheet fixed debt and can give swapping a run for its money. The penalty is simple math, so I won’t break it out, but from our perspective, it provides an easy known quantity. The tradeoff is there’s no potential upside (like with a swap) if rates are higher in the future.
When our clients evaluate the two options, they often reach out for help quantifying the potential swap breakages for an apples-to-apples comparison. If you’re not doing the same, give us a shout.
You get to work with us!
One of the most common things we hear is that borrowers don’t realize they can engage an advisor to help with their swap, since they’re trading with the underlying lender. In 99% of cases, the underlying lender will remain the hedge provider, our scope of work just looks different than what it does for a cap purchase.
In lieu of taking the hedge out to market and running an auction, we bring our expertise to your side of the table to help negotiate and execute directly with the lender. In addition to looking out for your best interests, our involvement includes:
- Verifying the rate before you lock it in
- Negotiating the ISDA agreement
- Quantifying and negotiating the credit charge
- Quarterbacking the pre-trade documentation
- Strategic dialogue around structure
- Term sheet comparison
Interested in seeing what’s out there for one of your assets, give us a call at 704-887-9880, email us at pensfordteam@pensford.com.
