If interest rates continue to rise, borrowers may be exposed to future rate increases related to longer-term debt.
A forward starting swap can help to manage interest rate exposure and align a borrower’s interest rate risk with his or her risk tolerance.
The forward starting swap is intended to mitigate anticipated interest rate exposure beginning at a future date for a predetermined period of time.
A forward starting interest rate swap is a variation of a traditional interest rate swap. It is an agreement between two parties to exchange interest payments beginning at a date in the future. The key difference is when interest payments begin under the swap. Interest rate protection begins immediately for a traditional swap. With a forward fixed rate swap, payments are scheduled to start on a future date. Forward swaps can be customized to manage all or a portion of a company’s floating-rate debt or to achieve a desired fixed-to-floating interest mix.
Forward starting swaps are commonly used in financings that include a draw period to help manage forecasted debt or to hedge bond issuances. For example, a borrower with a draw period followed by a term loan might prefer to lock in a forward starting swap to become effective when the draw period concludes. This provides the borrower with a known fixed rate at the conclusion of draws. Terms can be customized to match the details of the loan and can be amended (subject to certain costs) should the project timeline adjust from its onset.
Why should you consider using a forward starting interest rate swap as part of your company’s risk management strategy?
The additional cost to forward start an interest rate swap relative to a swap that starts immediately (the “forward premium”) is at multiyear lows. This decline in forward premiums allows borrowers with floating-rate debt to remain floating until the swap becomes effective, while at the same time locking in a known fixed rate to manage future interest rate risk.
Short-term Treasury yields have outpaced the rise in longterm yields, driving the flatness of the yield curve. Since the Federal Reserve first announced that it was starting to unwind its balance sheet and raise the target interest rate, short-term yields rose to or above the 20-year average. However, even with transparency from the Fed around future rate hikes, there remains some uncertainty about the pace and longevity of future hikes. As a result of long-term rates trading well below their respective long-term averages, the cost to forward start a swap has declined in recent years. The Federal Open Market Committee (FOMC) expects that economic conditions will evolve in a manner that will warrant further gradual increase in the federal funds rate, which will likely drive long-term rates higher and, therefore, forward premiums as well. This presents an opportunity for borrowers with future expected debt obligations to leverage low forward premiums.
The 10-year Treasury yield closed at an all-time low on July 8, 2016, at 1.3579%, six months prior to the first interest rate hike since before the recent financial crisis. Since that point, rates have only increased approximately 1.6% (as of May 1, 2018, the 10-year Treasury yield is 2.9644%). Comparing today’s levels to the pre-recession high of 5.932%, we see that rates are still historically low. The forward starting swap allows borrowers to float for some period of time with the interest rate fixed for future borrowing exposure when rates may be higher.
The Federal Reserve has indicated it will continue increasing floating rates.
Jerome Powell’s first meeting as chairman of the FOMC was conducted on March 20 and 21 and provided additional guidance to the markets. The Fed offered insight into a more hawkish policy (favoring tighter monetary policy with higher interest rates) versus the market expectations, which drove rates higher.
A number of FOMC members believe that there could be as many as three additional 25-basis-point hikes in 2018 followed by continued tight policy into 2019 and 2020. Given the projections of additional rate hikes in the near future, the forward starting swap is an attractive strategy for locking in the current fixed rates.
It is an opportune time to reevaluate your interest rate risk profile on existing and forecasted debt to ensure your company is at its desired fixed-to-floating mix.
Leveraging the use of a forward starting swap is one way to take advantage of historically low floating rates in the near term while locking in future debt obligations based on today’s market environment and multiyear low forward premiums.