Cancellable Swaps 101

Banks are back, rates are up, many hold periods are longer, and the volatility continues. A common topic of discussion when our clients are evaluating bank swaps is “What term should I go with?”

• On one hand, a shorter term reduces the potential for a prepayment penalty
• On the other, not hedging long enough leaves the borrower exposed if the business plan moves slower than expected

One potential solution is what’s known as a cancellable (or callable) swap. Cancellable swaps provide the borrower a fixed rate, just like a vanilla swap. However, at the time of trading, the borrower includes the right to terminate the swap on or after a pre-determined future date without a penalty.

This provides flexibility to get out of the swap if rates are lower, when there would otherwise be a penalty to do so. This applies whether you’re exiting to sell/refi, or if rates are lower and you just want to re-hedge to get the benefit of that.

Let’s look at a simple scenario.

     Loan type                             Bank lender

     Loan amount                       $50,000,000

     Loan term                             3+1+1

     Interest rate                         SOFR + TBD%

     Hedge requirement           Minimum 3 years at 4.50% (excluding spread)

Perhaps this is the refi of an asset where you anticipate needing 2-3 more years before selling. A common strategy is to pick a 3 year swap, which aligns with the business plan and initial maturity. 

All swaps terminate at par, meaning that at the end of year 3, there’s never a breakage.

Maybe your investment committee is wanting to fix more/longer and is pushing you to swap the full 5 years, though. The rates aren’t all that different after all!

You’d be rightfully concerned about the potential prepayment penalty. The table below outlines the bps of notional penalties under different rate environments at the end of year 3.

• The market currently projects the future 2 year swap rate to be 3.63%. If rates follow expectation, the breakage would be a manageable 0.28% of the amount hedged
• If rates are 100 bps below expectations, implying a 2.63% 2 year swap, the breakage jumps to 2.31% of the amount hedged 
  
  

After weighing the risks, some groups may still proceed with the 5 year swap. Before pushing go, let’s look at a cancellable feature. Including the ability to terminate the swap on or after EOY 3 would increase the rate around 0.37% to 4.14%.

The extra 0.37% is a meaningful difference, but is it worth it?

• Over the first 3 years of the loan, the additional 0.37% increases the interest expense by $555,000
• In order for the vanilla swap breakage to exceed $555,000 at the EOY 3, rates would need to be ~41 bps below current expectations
  • This implies a 2 year swap rate of 3.22% or just a couple more cuts than the market currently expects

If the deal doesn’t pencil with the additional 0.37% included, a simple strategy to balance the risks is shortening the term to 4 years. Or maybe consider a hybrid hedging strategy – more on that here.

For reference, here are the current costs for other cancellable swap structures today.

• 5 year swap cancelable after EOY 3 – 0.37%
• 5 year swap cancelable after EOY 4 – 0.17%
• 4 year swap cancelable after EOY 3 – 0.21%
• 3 year swap cancelable after EOY 2 – 0.29%
• 2 year swap cancelable after EOY 1 – 0.39%

Interested in discussing cancelable swaps further or weighing other potential strategies for one of your upcoming financings? Give us a call at 704-887-9880, email us at pensfordteam@pensford.com, or respond directly to this.

Helping negotiate and place swaps directly with the underlying lender is one of our core competencies. Your lender’s swap desk is looking out for their interests. Let us help you look out for yours.

Pensford has been a trusted partner of real estate investors for over 16 years. Our deep industry expertise and transparency enables our clients to make informed decisions, helping to protect their investments from market volatility and ensure stability.