Fixed vs Floating Revisited

Over the past couple of years, many borrowers have opted for fixed rate debt to maximize proceeds and/or reduce interest rate exposure. However, long time readers may also recall the following conclusions from our Fixed vs Float analysis (link here):

• Generally, the market dramatically overestimates the path of Fed Funds
  • The most notable exception to this, however, is during a tightening cycle
• There’s an asymmetric risk/reward – when there are savings, the magnitude of those savings when floating is substantially greater than when fixed
• The longer the term, the greater the likelihood that floating will save money relative to the fixed rate alternative

With floating proceeds more closely aligned with fixed today, coupled with expectations of lower floating rates, many borrowers may be weighing a switch back. We’ve also seen an uptick in floating rate bank loans, which often come with more flexibility around the hedge (more on that here). Therefore, we thought it was a good time to revisit historical fix vs float performance and the benefit of diversification.

Spoiler alert – a simple 50/50 fix/float percentage provides a considerable amount of certainty, while meaningfully reducing the opportunity cost of fixing all the debt in most environments.

The graph below outlines the cost/(benefit) of swapping for 2, 3, 5, 7, and 10 years. This is a simple comparison of the swap rate on the date shown to the average of 1ML/SOFR over the respective hedge term.

Some notes:

• If the swap rate > floating, there was a net cost, which is shown as a positive number (and vice versa)
• The % shown in the graphs represents the per annum cost/(benefit) for the respective term
• The cost/(benefit) of more recent swaps, or those with longer terms that haven't matured yet (e.g. a 10-year locked in 2020) is projected based on the forward curve
  
  

Some initial thoughts/takeaways:

• Fixing for 10 years has typically resulted in a meaningful net cost; however, some 10-year swaps done in 2015 are shaping up to have a slight benefit
  • Note, the outcome of rates locked in 2020 still won’t be known for another five years
• There have been periods where the 5-year swap had a similar net cost to the 2-year (2018) and other periods where it provided a greater benefit (2020)
  • In other words, picking a 5-year term hasn't always been worse than other shorter options
• The 2-year swap typically had the lowest cost but also the smallest benefit

In a perfect world, one would be able to strike a balance between the two extremes. With that in mind, we investigated a few different hedging strategies for 5-year terms:

• 5-year 100% swap
• 5-year 50% swap and float the other 50%
• 100% 3-year swap, then a 100% 2-year swap
• 5-year 50% swap and cap the other 50%  
  • The cap would be a 3-year initial term, then 2-year extension

The following graph compares these strategies but excludes the swap/cap scenario.

As seen above, a lot less was left on the table by doing a combination of swapping/floating or shorter-term swaps over just fixing all 5 years.  The exception being 2020 when 5-year rates were 0.50%...

Since the swap/cap scenario has more moving parts, we picked a couple dates to examine and see how it stacked up. 

June 2000 (a peak)

• 5-year swap rate was 7.58%
• 5-year LIBOR average was 2.72%
  • 100% swap net cost - 4.86%
  • 50% swap / 50% floating net cost - 2.43%
  • 50% swap / 50% cap net cost - 2.43%
  • 100% 3y / 2y swap net cost - 2.43%
    • Yes, the outcomes were all the same

For the swap/cap strategy, we assumed a 3-year initial cap at the swap rate + 1.00% (8.58% strike) followed by a 2-year at the prevailing 2-year swap rate + 1.00% (2.42% strike).  The combined cost of the two caps spread across 5 years amounted to 1.8 bps per month.  

May 2020 (a dip)

• 5 year swap rate was 0.41%
• 5 year LIBOR/SOFR average was 2.70%
  • 100% swap net benefit - (2.29%)
  • 50% swap / 50% floating net benefit - (1.15%)
  • 50% swap / 50% cap net benefit - (1.34%)
  • 100% 3y / 2y swap net benefit - (0.90%)

We assumed a 3-year cap at the swap rate + 1.00% (1.40%) and a 2-year cap at the swap rate + 1.00% (5.20%).  The cap cost added roughly 0.5 bp per month.  

Takeaways

Since the cap cost worked out to be negligible, the 50/50 swap/float and 50/50 swap/cap strategies were basically the same when rates fell off a cliff. However, when the market was underestimating the path of rates, there was a material benefit to having the cap in place.

• If you're weighing bank loans where a swap is on the table, a partial swap (with no hedge or a cap on the rest) is a simple way to reduce volatility while still retaining floating exposure
• If you have a fund model or monitor interest rate risk from a portfolio level, beginning to mix in some floating rate debt to diversify can provide a similar outcome

Keep in mind, a big downside to a shorter term loan/hedge is refi/extension risk.  It's great if you get to lock in when rates have fallen significantly, but if you can't get a loan or rates are higher at maturity, then it does you no good.