“What hedge structure’s interesting right now” is a common question. Today, capped corridors have my attention. That’s especially true for borrowers focused on the most efficient use of funds in lieu of the lowest upfront premium. Let’s dig in.
Traditional Corridor
This is a combination of two interest rate caps, one purchased (eg 3.00%) and one sold (eg 4.00%). The idea is that by selling back a higher strike, you recoup the value (volatility premium) of the 4.00% cap in exchange for protection above that level.
In other words, if SOFR exceeds 4.00% in this example, your net rate starts increasing 1-1 for each basis point SOFR is above that level.
With the above in mind – a traditional corridor DOES NOT satisfy a lender hedge requirement since it doesn’t provide for a max all in rate. They are typically used for elective hedges and that’s why they’re popular with developers. More on hedging construction debt here.
A capped corridor is what’s needed when there’s a lender hedge requirement.
Capped Corridor
This is where you buy one more cap (two bought, one sold), and that third cap puts a hard ceiling on your rate. For instance, buy 3.00% / sell 4.00% / buy 5.00% has a net 4.00% max rate.
Here’s how the math works:
Let’s look at pricing assuming a $50mm 2 year hedge is purchased.
A vanilla 2 year 4.00% cap costs $354k
A buy 3.00% / sell 4.00% / buy 5.00% capped corridor costs $831k
For reference, here are the approximate market values (excluding bank adjustments) of each leg of the trade:
Takeaway – you’re frontloading a lot of interest with the goal of reducing/eliminating the net cost of the cap. The capped corridor provides a lower rate paid until SOFR reaches 5.00%, provides the equivalent of a 4.00% vanilla cap (meaning it still satisfies a lender hedge requirement), and is arguably a more efficient use of funds.
The risk is that if the Fed cuts rates instead of hiking or even just holding, the net cost could potentially exceed that of the vanilla 4.00% cap. For reference:
Before you write this off as “too speculative”, consider that some borrowers regularly pay up for deeply in-the-money caps (<3.00% strike today), which frontload more interest but reduce the portion of the cost attributed to volatility. If you’ve ever bought an in-the-money cap, a capped corridor has a similar risk but might be a more efficient solution.
What happens if you raise the strike?
A buy 3.50% / sell 4.00% / buy 4.50% structure results in the same max rate with a lower upfront cost ($495k).The tradeoff is a higher net cost ($73k loss) vs the lower strike strategy ($71k gain).
Using a capped corridor when all the strikes are out of the money (think 4%+) results in a higher net cost than the equivalent vanilla cap.It would only be beneficial if specific rate scenarios play out.
If you follow but would benefit from a visual, check out the interactive cashflows at the link below.
Note, some lenders may push back on the strategy due to the moving parts. However, just like a vanilla cap, the structure always has a net positive MtM to the borrower, the borrower’s only obligation is the upfront premium, there’s no credit exposure to the borrower or lender, and the hedge still provides for a max rate.
Think this is strategy is worth pursuing but you haven’t worked with us before? Let’s make this the one! Give us a call at 704-887-9880, email us at pensfordteam@pensford.com, or respond directly.
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