Interest rate hedging is often associated with protecting against floating rate movements. However, movements in fixed rates can be effectively hedged as well. Here are a few ways that common fixed rate risks can be hedged.
1. Prepayments
As fixed rates fall, prepayment penalties rise. Fixed rate borrowers with an upcoming yield maintenance, make-whole, swap breakage, or defeasance penalty can purchase a hedge to offset the impact of falling rates.
Prepayment hedges are typically purchased for an upfront premium and are settled in cash at the time of closing. That cash settlement can then be used to offset the rise in the prepayment penalty.
These hedges are more cost-effective for near-term payoffs with a generally known prepayment date. Hedging longer time horizons where the prepayment date is less certain is also possible, but for a higher premium. To help set an order of magnitude, here are a few generic quotes in basis points of loan amount to hedge a prepayment on a loan with three and five years remaining:
2. Rate Locks
Borrowers with upcoming rate locks, whether internally fixed or through a swap, can also hedge rising rates.
Exactly like hedging prepayments but in the opposite direction, borrowers pay an upfront premium for a cash settlement later that offsets the rise in rates. The borrower can use that cash settlement to either buy down the rate or hold the funds and account for the increase internally.
A shorter time horizon and greater certainty around the closing date results in a lower premium and vice versa. Here are some generic quotes to hedge a seven-year and ten-year rate lock.
Have an upcoming fixed rate loan closing and concerned about the risk of rates moving against you? Whether a prepayment or rate lock, there’s a hedging strategy that may make sense for your deal.
Reach out to us at pensfordteam@pensford.com or (704) 887-9880 and we’d be happy to help you identify ways to mitigate your fixed rate risk.