It has been said that our brains are so amazingly designed that a single phrase or name can unlock memories that we have not thought about in years. Let’s test this out. What do you think of when I say “I’m Paul Harvey, and now…..”? If you are like me, you immediately hear Paul in that smooth southern drawl say “…. the rest of the story”.
A few weeks ago, we introduced Interest Rate Swaps. If you have not had a chance to read that article, be sure to check it out before reading any further. This week, I want to talk about “the rest of the story” and explore how the actual interest payments flow, discuss one of the major risks (or benefits) of an interest rate swap (aka the make-whole provision), and highlight a few really cool features that your interest rate swap can have.
To set the stage, let’s assume that you are going to purchase a new piece of equipment for $1,500,000. You are going to put down $300,000 and finance the remaining $1,200,000 for 7 years. You talk to your banker and he says that the variable interest rate the bank would approve is LIBOR + 2.25% (or L+2.25%). That seems like a good rate, but you think rates are going to go up in the next 7 years and you don’t want to bear the interest rate risk. So you ask for a fixed rate, which the banker provides at 5.35%. Because you read the previous article, you believe you qualify for an interest rate swap, so you also ask for an interest rate swap quote. For purposes of this discussion, let’s assume that the licensed interest rate swap dealer that the bank works with provides you a swap quote for 5.10%. This sounds like the best option and you draw up the paperwork.
Swap interest rates are typically set immediately after you sign all of the loan documents. For our discussion, LIBOR is currently 2.00%, which would mean the variable rate (L+2.25%) is 4.25%, and you were able to lock the interest rate swap in at 5.10%. You are happy with the deal, but when you receive the first monthly statement, you notice that you receive two invoices (as some banks do). One for the variable rate, L+2.25% (4.25%) and one for the difference between the swap rate and the variable rate (5.10% – 4.25% or 0.85%). The image below shows how the loan interest payment cash will flow:
The entrepreneur will pay a total interest payment of 5.10%. Interest payment #1 (4.25%) will be paid and kept by the bank. Interest payment #2 (0.85%) will be paid the bank and passed along to the counterparty (assuming the bank uses a counterparty).
So what happens if the LIBOR rate falls. For example, from 2.00% to 0.75%.
To the entrepreneur, there is no effective change. You still have to pay 5.10% in interest. The only difference is that interest payment #1 is less (3.00% vs. 4.25%) and interest payment #2 is more (2.10% vs. 0.85%).
But what if the LIBOR rate increases? Let’s see what would happen if LIBOR increased from 2.00% to 4.50%:
In this scenario, the variable rate is 6.75% which is more than the fixed swap rate of 5.10%. Technically, the bank would charge the entrepreneur the 6.75%, but they would also simultaneously apply a 1.65% (6.75% – 5.10%) credit that they receive from the counterparty. This means that to the entrepreneur – the rate always remains the agreed upon 5.10%!
Imagine that after you bought the piece of equipment, your business just took off and now you were sitting on a pile of cash, and you wanted to pay this loan off. Here is where we get into the discussion of one of the major risks associated with interest rate swap agreements – the make-whole provision. Which is a fancy way of determining the difference between the rate that you lock and the replacement swap rate. Not to get to bank-nerdy, but this is the net present value of this difference for every payment that has to be made. Definitely you want to discuss this with a licensed swap professional, along with your legal, tax, and accounting teams.
For purposes of our discussion, let’s assume that when you want to pay your loan off, LIBOR has decreased to 0.75%. From your loan, the counterparty is getting much better rate than the replacement rate, so if you pay off, you will have to pay the counterparty a make whole charge. On the flip side, let’s assume that LIBOR has increased to 4.50%. With every payment, the counterparty is having to pay the bank an immediate offset for the amount of interest that is owed above the agreed to swap rate. If you paid the loan off, the counterparty would have to pay you in order to make you whole for the net present value of all these offset payments. As a result, you would receive a make-whole credit! Not a bad option, you pay the loan off, eliminate your interest expense and get handed a check to do so!
I have worked with many entrepreneurs who have managed their interest rate risk through the use of interest rate swap agreements. I personally like the creativity that comes with interest rate swap agreements. Some of my favorite include:
- A forward-looking swap – which is where you can close the loan today and have a specific amount of variable interest rate payments; followed by a fixed rate period – with the fixed rate specified today. For example, if you are constructing a new building, you may receive 12-months of interest only payments followed by fixed principal and interest payments. A forward-looking swap will allow you to float the rate during construction, and then when the loan is fully drawn and converted to principal and interest payments, the rate will automatically convert from a variable rate the previously agreed to swap rate.
- Bermuda swap provision. This provision may allow you to terminate the swap at a date earlier than the agreed to maturity date.
Interest rate swaps are great tools in the right situation, for the right entrepreneur, but they are also regulated financial transactions that require a license to “sell”. I want to be perfectly clear that I am not licensed to sell interest rate swap products. Before entering into any swap agreement, everyone should contact the licensed professional they are dealing with, along with their legal, tax, and accounting advisers. They can provide you with the proper legal, tax, and accounting perspectives to ensure that you understand and agree with the risks associated with interest rate swaps (not just the ones discussed here). The purpose of this article it to provide a general understanding of interest rate swaps and to stimulate conversation as how entrepreneurs can use this to help achieve their strategic goals.
Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Hit the connect button on LinkedIn or Facebook NOW and together we will work towards hitting your 10-year target. Along the way we will increase your profit, strengthen your leadership skills and define your strategic vision. This will lead to confidence in your path, freedom to dream up bigger targets and a strategic banking relationship. When we connect, tell me if you have ever heard of an interest rate swap before reading this article.
Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.
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