Buying Down the Swap Rate
With rates and volatility at elevated levels, many borrowers are looking for ways to hedge debt more efficiently. One common strategy is to buy a deeply in-the-money (ITM) cap, but when the lender has the ability to offer swaps, an alternative is locking a swap and buying down the rate to something below market.
In the following resource, we’ll look at buying a 3.00% strike cap and locking a swap with a rate buydown to 3.00% using the terms below.
Index Term SOFR
Term 3 years
Cap vs Swap
Many borrowers use caps when the anticipated hold is 5 years or less, rates are expected to fall, and/or to retain prepay flexibility. The downside to capping, especially in the current environment, is that a significant portion of the cost is attributed to time/volatility.
The current cost of a 3 year 3.00% cap is $4.7mm. If rates follow market expectations over the next 3 years, the cap is projected to pay out $2.85mm, meaning that $1.85mm (or 39.4% of the cost) is attributed to time/volatility. In other words, most of the premium is not expected to be recouped. Caps are intended to be insurance after all, but you’re probably interested in minimizing cost and efficiently using funds.
The current 3 year swap rate, assuming a generic 0.15% credit charge, is 4.15%. In lieu of purchasing the cap, a 3 year swap could be locked and the rate bought down from 4.15% to 3.00%.
The present value of each basis point (or PV01) is $28.4k, meaning the cost to do so would be $3.27mm ($28.4k * 115). This results in the same 3.00% rate but a lower cost to get there.
Cap cost $4,700,000
Swap buydown $3,267,000
If rates followed expectations and borrower didn’t prepay early, the swap would save $1.43mm over floating with a cap. The reason being, where caps are driven by rate expectations and volatility, swaps are only driven by rate expectations and have no volatility component.
The two main risks of swapping include:
- Missing out on floating lower if/when rates fall
- The potential for a prepayment penalty if the swap is terminated early
While the risks aren’t eliminated, the $1.43mm savings and below market rate help mitigate them.
How much would rates need to fall for capping to be the better choice?
- In order for floating with a cap to be more beneficial than swapping over a 3 year period, SOFR would need to average around 0.50% below 3.00% (or 2.50%) to save $1.43mm.
- If it took two years for SOFR to fall below 3.00%, SOFR would need to average around 1.50% during year 3 for the cap to be more beneficial.
How much does the rate buydown help with the prepayment penalty?
- If borrower chose to prepay at the end of year 2 when 1 year remained on the hedge, in order for the swap breakage to exceed $1mm, 1 year rates would need to be around 2.00%.
- Had borrower locked a vanilla swap at 4.15%, the swap breakage with 1 year rates at 2.00% would be over $2.1mm.
Some other benefits of swapping with a rate buydown include:
- Potentially obtain higher loan proceeds
- Generally results in a lower swap credit charge
- Below market rate means the MtM is in favor of borrower on day one
- Improved cashflow compared to the vanilla swap without a buydown
If you’re looking for an efficient way to hedge and your lender offers swaps, an option to consider is swapping with a rate buydown.