Hedging a Floating-Rate Term Loan with a Swap or Cap
A UK logistics company has a £60 million five-year term loan priced at SONIA plus 180 basis points, with quarterly resets. It wants to fix its interest cost for the next three years because it is bidding for a long-term contract with fixed revenues. Its bank quotes a three-year payer swap at 4.10% against SONIA, and a three-year SONIA cap at 4.50% for an upfront premium of 1.35% of notional. The company's board is risk-averse but may sell a division in two years, which would allow early repayment of the loan. The swap documentation includes a standard ISDA schedule with a CSA and daily variation margin above a £1 million threshold; the company has no existing derivative counterparty exposure. SONIA is currently 4.00%, and the company's credit spread has been stable but could widen if the division sale is poorly received.
1. Calculate the all-in fixed rate if the company enters the payer swap, and the maximum all-in rate under the cap, including the upfront premium amortised over three years.
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Under the payer swap, the company pays 4.10% fixed and receives SONIA, while paying SONIA + 1.80% to the lender. The SONIA legs offset, so the all-in fixed rate = 4.10% + 1.80% = 5.90%.
Under the cap, the loan rate is SONIA + 1.80%. If SONIA rises above 4.50%, the cap pays the excess, so the maximum loan rate before premium is 4.50% + 1.80% = 6.30%. The upfront premium is 1.35% × £60m = £810,000. Amortised simply over three years, that is £270,000 per year, or 0.45% of notional per year. The maximum all-in rate is therefore about 6.30% + 0.45% = 6.75%, before any financing cost on the premium. At current SONIA of 4.00%, the cap structure costs 4.00% + 1.80% + 0.45% = 6.25%, versus 5.90% under the swap.
2. Explain how the possible division sale affects the choice between the swap and the cap, including breakage costs and prepayment.
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If the company enters the swap and then prepays the loan after two years, it must unwind the swap. The breakage cost is the swap's mark-to-market: if rates have risen, the company owes the present value of the remaining fixed payments above market; if rates have fallen, it may receive a gain. That unwinding cash flow can be large and unpredictable, and it would hit exactly when the division sale is being executed. The cap has no breakage cost: the premium is paid upfront and the option can simply be allowed to expire. The cap therefore gives flexibility if early repayment is a realistic possibility. The trade-off is that the cap costs more at current rates (about 6.25% all-in versus 5.90% fixed) and has a higher maximum cost. If the division sale is unlikely or the company values certainty above flexibility, the swap is cheaper; if the sale is plausible, the cap or a swap with a break clause is safer.
3. Assess the counterparty risk and collateral implications of the swap, and recommend a hedging structure.
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The swap creates bilateral counterparty exposure to the bank. If the swap moves in the company's favour and the bank defaults, the company may lose the value of the hedge; if the swap moves against the company, it must post collateral under the CSA once exposure exceeds £1m. Daily variation margin reduces credit risk but creates liquidity demands, especially if rates fall sharply and the swap becomes a liability. The cap also creates counterparty exposure until expiry, but the company has already paid the premium and there is no daily margin. Recommendation: if the division sale is a genuine possibility, use the cap or a swap with an explicit break clause, and negotiate the CSA threshold and collateral terms carefully. If the company is confident it will keep the loan for three years, the swap is the cheaper way to fix at 5.90%. A collar could reduce the cap premium but would reintroduce downside if SONIA falls.