Hedging a Floating-Rate Term Loan: Swap, Cap, or Zero-Cost Collar
Halcyon Foods has a $250 million term loan priced at SOFR + 200bp, amortizing 5% of original principal annually and maturing in four years. SOFR is 3.60%, so the current all-in cost is 5.60%. The treasurer expects SOFR to reach 4.35% within a year and wants certainty; his annual bonus is tied to reported interest expense. A bank quotes three 3-year structures on the full $250 million: a payer swap at 4.30% fixed; a 4.75% cap for an upfront premium of 1.10% of notional; and a zero-cost collar buying the 4.75% cap and selling a 3.25% floor. The CFO wants to retain the benefit if rates fall. Halcyon's loan covenant requires EBITDA/interest of at least 3.0x; EBITDA is $95 million and interest expense is $14 million.
1. Compare the three structures' all-in cost if SOFR rises 75bp and if SOFR falls 100bp, and assess the covenant constraint.
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The premium on the cap is 1.10% of notional = $2.75 million; spread over three years that is roughly 37bp per year of all-in cost.
| Scenario | Unhedged | Payer swap @4.30% | Cap @4.75% | Zero-cost collar 4.75/3.25 |
|---|---|---|---|---|
| SOFR +75bp (4.35%) | 6.35% | 6.30% | 6.35 + 0.37 = 6.72% | 6.35% |
| SOFR −100bp (2.60%) | 4.60% | 6.30% | 4.97% | 5.25% (floor) |
Covenant headroom. EBITDA/interest = 95/14 = 6.8x against a 3.0x requirement. Even under the swap at 6.30% on an average balance of roughly $237 million, interest is about $15 million, or 6.3x. Interest would have to more than double - SOFR rising above roughly 12% - before the covenant binds.
Implication: the covenant does not require certainty. The swap buys protection the company does not need and pays for it by giving up 170bp of benefit in a rate decline. The cap costs about 37bp a year and preserves the downside. The collar is free but its floor at 3.25% is only 35bp below spot, so the company surrenders most of the fall it is trying to keep.
2. Recommend a structure given the CFO's stated objective, and address the treasurer's recommendation.
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Recommendation: buy the cap, on an amortizing notional.
- It caps the all-in cost at about 6.75% plus the amortized premium, preserving the CFO's stated objective of benefiting if rates fall.
- The premium (about 37bp a year) is small relative to the covenant headroom and to the interest cost volatility being removed.
- Unlike the swap, the cap is an option: no termination cost and no obligation if Halcyon prepays or refinances the loan. With 5% annual amortization and a four-year maturity, refinancing is plausible, and a swap would leave a breakage payment exactly when the company is renegotiating.
- The collar is rejected because the 3.25% floor undercuts the CFO's objective; the swap is rejected because it converts a financing decision into a rate view in the opposite direction of the company's stated preference.
On the treasurer: his bonus is tied to reported interest expense, which gives him a personal interest in a structure that minimizes near-term reported cost (or in a narrative of certainty) rather than in the structure that best matches the company's stated risk preference. That is a conflict of interest - Standard VI(A) requires disclosure to the employer. The CFO should require the treasurer to disclose the incentive and should evaluate the hedge against a written treasury policy (for example, a hedge ratio band of 50–70% of floating exposure over a rolling 24 months), not on the strength of one officer's forecast.
3. Identify the structural and execution risks in the quoted alternatives that the treasurer's analysis omits.
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- Notional mismatch (over-hedging). All three quotes are on the full $250 million for three years, but the loan amortizes 5% annually. By year three, outstanding principal is about $212.5 million; the swap would hedge $37.5 million of exposure the company no longer has, which is a speculative position, not a hedge. Hedging derivatives must be sized to the exposure they hedge; the fix is an amortizing notional schedule matching the loan.
- Forecast risk. The treasurer's 75bp view is embedded in the choice, but the swap's 4.30% fixed rate is roughly the market's expectation of average SOFR over three years, plus a term premium. Choosing the swap effectively bets that the market's forward path is too low; a hedge should be sized to policy, not to a forecast.
- Basis and reset risk. The loan resets on a specific SOFR tenor and compounding convention; the hedge must match it. A mismatch in reset dates or day count leaves residual exposure that is invisible in the summary cost numbers.
- Counterparty and documentation risk. A three-year swap carries counterparty exposure and requires an ISDA plus collateral support; a cap does too, but premium is paid upfront and exposure falls to zero quickly. Confirm credit lines and collateral posting capacity before signing.
- Hedge accounting. Designation and documentation must be in place at inception for the hedge to qualify for hedge accounting; otherwise mark-to-market swings in the derivative flow through earnings, which is precisely the volatility the treasurer says he wants to eliminate.