Economic conditions ebb and flow like the tides, and interest rates are no exception. As the rate environment shifts, it's crucial to consider the various instruments available to lock in your rate or hedge your exposure. For borrowers, the likelihood of prepayment should always be top of mind when choosing among rate-fixing products.

Generally, internally fixed rates come with a step-down prepayment penalty. On the other hand, an interest rate swap, which synthetically fixes the rate, involves a two-way make-whole provision. A more sophisticated option is the interest rate swap collar. Unlike a fixed rate, a swap collar binds the rate within a range of a minimum and maximum rate; for example, having 5% as the maximum rate and 4% as the minimum. This involves buying a cap (the upper limit) and selling a floor (the lower limit). While a swap collar may have a slightly higher upfront expense, it often results in lower costs if the hedge is unwound before maturity (breakage).

When dealing with derivatives or swaps, having an experienced advisor by your side is crucial to navigate these complex waters effectively. Here is how it played out for one of our clients recently:

Case Study: Tallahassee Orthopedic Clinic

An orthopedic practice was interested in a collar due to the lower breakage costs because prepayment during the term was a real possibility. The bank provided an indicative trading level for a costless collar, setting a strike price of 4.75%. Initially, the floor rate was quoted at 3.25%. When the execution call took place, however, the bank attempted to increase the floor rate to 3.45%, which would have cost the borrower an additional $60,000 for a notional loan amount of $4.8MM.

The markets had been flat and trading conditions were static over the preceding days. Fortunately for the borrower, they had CMAC Partners in their corner, monitoring the trade closely. With some smooth talking, CMAC was able to successfully negotiate a refreshed quote which traded much closer to the initial indicative level.

This scenario underscores a vital point: while derivative products, in this case interest rate swap collars, offer significant opportunities to hedge risk and exposure in volatile economic climates, they also present chances for banks to profit at your expense. Staying vigilant and consulting with a knowledgeable swap advisor can make a substantial difference in securing favorable terms.