Cancellable Swaps 201

A traditional cancellable swap is where the borrower buys the right to terminate their hedge with no penalty on or after some pre-determined future date. We dig into those here.

Now, let’s look at a less common structure – a cancellable swap where the borrower sells the right to terminate in the future.

This structure still provides the borrower with a fixed rate. However, the hedge provider has the right to terminate the swap on a future date (this is typically structured as a one time right). Why would someone do that?

Two reasons:

1. Selling the bank a cancellable feature lowers the rate.
2. The initial rate savings may be more important than hedge duration. There’s no breakage owed if the option is exercised by the hedge provider – the swap just goes away, and you revert to floating.

To help paint the picture, 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)

Today, many borrowers are simply swapping 3 years to put the hedge requirement to bed.

However, if you anticipate extending the loan at EOY 3, an alternative option is to lock a 4 year swap and sell an EOY 3 termination option. The sale of the option lowers the rate in exchange for the hedge provider’s one time right to terminate your swap on that date.

The vanilla 4 year swap has basically the same rate as a 3 year.

If you sell an EOY 3 termination option, the rate goes down approximately 0.16% to 3.50%.

One of two things would happen at the end of year 3:

1. 1 year swap rates are above 3.50% - the bank would terminate your swap, and you go back to floating
2. 1 year swap rates are below 3.50% - the option expires worthless and you keep the swap

In the first scenario, you saved 0.16%/yr over the three year period but are forced to re-hedge in a higher rate environment. If you’re planning to sell/refi, you might not care that the swap is gone. Keep in mind, this is the same risk that you would have faced by doing a vanilla 3 year swap anyway.

In the second scenario, you saved 0.16%/yr over the vanilla 4 year structure. The reduced swap rate also helps lower the breakage if you decide to terminate at some point in year 4.

Cancellable pricing varies widely depending on the lender, hedge structure, credit charge, and market environment. For instance, increased volatility has negatively impacted cap pricing, but it has increased the value of these options.

One structure that we find particularly interesting is a 2 year swap with a one time right to terminate at EOY 1.

• The vanilla 2 year swap rate is around 3.67%
• Selling the option lowers the rate roughly 0.22% to 3.45%

A year from now, one of two things happens:

• The 1 year swap rate is >3.45% and your hedge is terminated
  • The vanilla 1 year swap rate is around 3.75%, meaning you would have saved ~0.30% over that structure
• The 1 year swap rate is <3.45% and you keep your swap
  • You saved 0.22% over the vanilla 2 year

Since SOFR is ~3.66% today and all vanilla swap rates are at or above that level, most swaps no longer provide positive carry day one. However, the 2 year structure highlighted above has a rate below spot SOFR, meaning that it provides day one cashflow.  

If you’re wondering how/why there’s no breakage due, here’s what’s happening behind the scenes.

• When the swap is locked, you’re selling the bank a swaption with a strike that matches the swap rate. Using our 2 year example above:
  • If the 1 year swap rate a year from now is 4.00%, the swap is in the borrower’s favor by 0.55% or a positive MtM of $275k
    • Since the swaption has a strike of 3.45%, the option is in the bank’s favor by 0.55% or $275k as well. This gain to the bank is a liability to the borrower
      • When the bank exercises the option, the borrower owes $275k which is collected by terminating the borrower’s swap
      • $275k swap value - $275k swaption liability = $0
    • If the 1 year swap rate a year from now is below 3.45%, the option expires worthless and nothing happens

One other thing to keep in mind – like any other swap, selling a termination option will require credit approval and an understanding of the risks prior to trading.

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.