Reducing the cost of capital: interest rate swaps
(As originally published in Corporate Risk Canada, Spring 2012 issue)
A key component of any financial executive’s job description is managing capital. However, what has become increasingly unclear in this period of financial turmoil is whether the principal focus is on minimizing the cost of capital or simply ensuring access to capital. While a key objective will always be to minimize cost, most would admit that the focus has changed to the latter.
There are risks associated with managing access to capital, particularly debt financing; and they can be broken down into three components:
- Availability/liquidity risk – Simply stated, there is risk that markets will be constrained and illiquid when seeking financing. We all remember early 2009, when many companies forced to seek financing were looking into a vacuum left by the exodus of many US and European institutions and an illiquid bond market.
- Interest rate risk – We are in a period of historically low benchmark yields and a relatively flat yield curve. Deferring a financing decision could potentially risk incurring higher interest rates.
- Credit spread risk – The recent volatility in Europe has magnified the risk of exposure to short-term movements in credit spreads. Many recent issuers chose to delay a closing due to temporary blips in spreads. Others will recall 2009, when credit spreads shot up to unprecedented levels.
A simple way to mitigate all three of these risks is to issue long-term fixed-rate debt. The longer the commitment of the financing, in terms of both interest rates and availability, the less exposure to any of these risks. A long-term bond could accomplish this, as would a long-term committed fixed-rate bank financing.
Financial executives are increasingly looking to financial derivatives to mitigate risk while minimizing capital cost. Interest rate swaps are commonly used to convert floating bank debt to fixed-rate financing. Typically, a borrower obtains financing by entering into a committed loan agreement where interest is priced on a floating rate basis by way of bankers’ acceptances (BAs).
A swap is a separate agreement whereby the borrower contracts with a counterparty (often the bank) to exchange fixed-rate interest payments for floating-rate interest payments. The interest rate swap market is highly developed and flexible with availability of customized draws, forward start rates and terms of up to 30 years.
Swaps can be either spot or forward starting, which allows a borrower to fix the rate of interest for a future draw.
With the current swap curve being relatively flat (it mirrors the benchmark yield curve), the cost of securing future fixed rate financing is not significantly higher than the spot rate for fixing the interest rate and drawing funds today.
Here’s an example of how a forward swap can reduce your cost of capital:
Let’s assume that you’re a non-investment grade borrower with access to committed floating rate bank debt at BAs plus 200 base points (bps). You are seeking to mitigate financing risk associated with a $20 million capital need in 12 months. You are looking to secure fixed-rate, interest-only financing with a bullet repayment in year 10. Based on recent indicative rates, you could enter into a swap today at an all-in cost of 4.45% and sleep reasonably well knowing you’ve done your part to mitigate risk. The only problem is that the cost of that certainty is redundant cash of $20 million and the associated carrying costs for 12 months.
With a committed bank financing agreement and a forward swap, you could achieve the same financial objective but at a reduced cost of capital. The same borrower could enter into a swap with a forward start date 12 months from today at approximately 4.69%, or just 24 bps higher than the spot rate. If you do the math, eliminating the 12-month carrying costs significantly reduces your cost of capital while still achieving your risk mitigation objectives.
Long-term fixed-rate financing with an immediate lump-sum drawdown can eliminate the three risks associated with financing. With a relatively flat yield curve, a combination of committed bank financing and a forward swap might achieve the same result but at a lower cost.
Brian Allard is a partner in Ernst & Young’s Transaction Advisory practice. Editor’s note: the above analysis is for illustrative purposes only and is based on interest rates prior to publication date.