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With uncertainty surrounding the future path of interest rates, borrowers can adopt strategies to help manage interest rate risk. One of these key strategies is the use of interest rate swaps, and agreement between two parties to exchange a floating rate for a fixed rate.

This can have several benefits. Borrowers can mitigate the uncertainty of floating rates, helping them budget with greater confidence to reach their financial goals. A swap agreement is also portable and can be used to hedge different loans.

It can even be transferred among banks. And because a swap agreement is separate from the original loan, there is flexibility in how it can be structured.

A swap can be for the full or partial loan amount, can start on a future date, or end before loan maturity. The agreement can also be terminated at any time by the borrower, provided that a payment may be due to or from the borrower.

Let's take a closer look at how swap agreements look. The borrower has a loan with a floating rate at SOFR, the Secured Overnight Financing Rate, plus a loan spread of 2.5%. As SOFR fluctuates, so does the loan's interest rate and, thus, the payment amount.

This borrower would like to remove this uncertainty, so they elect to fix the rate by entering into a swap agreement. Under this agreement, the floating rate is paid by the swap bank to the borrower. In return for receiving the floating rate, the borrower pays the swap bank a pre-negotiated fixed swap rate. In this case, 5.5%.

Let's look at how these two contracts, the loan and the swap, can provide a borrower with greater cash flow certainty. We'll first examine a situation in which the floating rate is less than the fixed swap rate at a given point in time. If SOFR is 2% for the interest period, the loan interest rate will be 2% plus the loan spread for a total interest rate of 4.5% which is paid to the lender.

With a swap agreement in place, the borrower will pay the agreed-upon fixed swap rate to the swap bank and receive the floating rate in return. In this case, the difference between the floating rate and fixed swap rate is 1% paid by the borrower.

Thus the sum of the loan and swap payments for this period results in the effective interest rate of 5.5%, which is consistent with the expectations of the borrower for a predictable, steady rate. But what happens when the floating rate is above the fixed swap rate?

If SOFR is at 4.5%, the floating rate will be 7%; SOFR plus the loan spread. The borrower makes a loan payment at this rate to the lender. To the swap bank, the borrower again pays the agreed-upon fixed swap rate of 5.5%, but now receives a payment that reflects the higher floating rate.

The result is an inflow for the borrower of 1.5% paid by the swap bank. The borrower's expectations are again met with an effective interest rate of 5.5% for that period. As mentioned earlier, an interest rate swap can be terminated before its maturity date.

When a swap agreement is terminated early, there can be a payment made either to or from the borrower, which can be material. This payment amount is known as the mark-to-market value of the swap. For example, assume a borrower is paying a fixed swap rate of 5.5%, but the current market replacement fixed swap rate is 3.5%.

In this case, the borrower would be required to make a payment to the swap bank to terminate the swap early. But if the prevailing market replacement fixed swap rate is above 5.5%, say, at 7.5%, the borrower will receive a payment from the swap bank upon termination of the swap.

Swaps can also include features that can mitigate exposure to potential costs associated with terminating a swap prior to its maturity.

With the swap agreement, the borrower benefits from a predictable, steady interest rate. Companies that have existing floating rate loans or are looking to borrow in the near future should consider the potential benefits and understand the risks of using swaps and other hedging solutions to mitigate fluctuations in their interest expense.

PNC's Derivative Products Group can provide more information about the potential benefits and considerations as they relate to your organization's circumstances and goals.