Higher Rates and Floating Rate Debt - Assessing Potentially Higher Costs

With the recent rise in inflation, many central banks are increasing interest rates in an attempt to cool the economy. This has led to the expectation of higher rates in the future. For example, the Canadian 5-year swap rate has moved from 1.26% to 3.72% year-over-year (+2.46%). This has led to an increase in forecasted rates for CDOR (BA’s) and CORRA in Canada, and for LIBOR and SOFR* in the US.

It follows that the interest costs on debt which is linked to these variable rates is also expected to go higher. Many Treasurers are asking if it is already too late to hedge against these higher costs. This simple analysis will quantify the risks related to higher rates.

This example looks at debt linked to US dollar SOFR. The analysis uses SOFR market rates and implied volatilities as of June 7, 2022 to determine a possible range of interest payments associated with SOFR-linked debt. SOFR 1-month forward rates were implied from SOFR end of day swap rates. Volatilities used to determine possible variation from the expected forward rates were implied from the end of day prices of SOFR interest rate caps.

The blue line represents the “expected” SOFR 1-month forward rate to the end of 2027. The magenta line represents the 1 standard deviation lower bound in these rates and the yellow line represents the 1 standard deviation upper bound in these rates. It is expected that there is roughly a 2/3rds probability that the observed rate will fall between these upper and lower bounds.

To see how this impacts interest payments, lets look at a term loan with the following details:

Principal: USD 400,000,000 (no amortization, no callability/putability)

Interest Rate: SOFR + 4.00%, paid monthly, with SOFR floored at 0.75%

Maturity: December 29, 2027

Applying the SOFR rates above, we get the following range of monthly interest costs:

To Hedge or not to Hedge

Management typically determines whether to hedge some or all of the debt based on their risk tolerance, which is influenced by the company’s ability to absorb an unexpected move higher in rates. Swaps can be used to effectively lock in market forward rates, plus some additional costs for their Bank’s market and credit risk and capital costs. SOFR caps can be bought to “cap” interest rate costs.

Scenario analysis can be used to layer on different types and sizes of hedges in order to lower the cost of adverse unexpected moves in rates to acceptable levels.

*SOFR = Secured Overnight Financing Rate

Libor = London Interbank Offer Rate

BA = Bankers Acceptance

CDOR = Canadian Dollar Offer Rate

CORRA = Canadian Overnight Repo Rate Average

Assumptions and Disclaimer

The analysis was done using SOFR rates and cap prices publicly available on the Internet. It was done for educational and discussion purposes only. For more information, please contact Ed Murphy at West Toronto Risk Advisory.

edmurphyconsulting@gmail.com

www.westtorontoriskadvisory.com