The Advantages and Disadvantages of Interest-Rate Swaps

Learn how an interest-rate swap could help protect you in times of upward rate trends.

Now could be an opportune time for companies to fix their floating rate debt – and an interest-rate swap is one strategy to consider.

What is an interest-rate swap?

By definition, an interest-rate swap is a contractual agreement between two parties – such as your company and a bank – to exchange interest flows on an agreed notional principal amount for an agreed period of time.

In practice, a swap allows you, as the borrower, to convert a floating rate loan to a fixed rate without disturbing the underlying borrowing (swaps also allow you to convert fixed rate debt to floating). In the exchange, the floating rate received offsets the floating rate paid in the underlying fund. So your company essentially pays a fixed rate plus any credit spread.

What are the advantages?

Swaps offer three key advantages over conventional financing. First, they offer added flexibility and diversity. For instance, you could use a swap to split a single loan into both fixed and floating rate tranches, rather than having the entire debt load as one or the other. In addition, if you have, for example, a long-term loan on a floating rate basis, a swap could allow you to shift to a fixed rate for just a portion of that time. Through these techniques, swaps allow you to separate the funding decision itself from the funding risk management.

Swaps also allow for a bilateral make whole provision. If you pay off your loan early, you could potentially face a pre-payment penalty if rates have fallen, as with traditional financing. But unlike traditional financing, you might also benefit if rates have risen.

Finally, swaps can allow you to lock in a fixed rate today for funding that will occur later. This lets you take advantage of a favorable rate environment even before you're prepared to take out the actual loan.

Are there disadvantages?

When investigating an interest-rate swap, there are two factors in particular that companies should consider. First is the basic understanding that a floating interest rate could actually average a lower cost than the fixed rate during the term of the swap.

Second, as a result of the Dodd-Frank Act, there are additional accounting and regulatory hurdles to cross with swaps. For instance, your company may be required to recognize the differential of the swap in your quarterly statements.

Where can I learn more?

If your company is interested in the potential opportunities presented by an interest-rate swap, we can help you determine if it's a suitable strategy for your unique needs. Simply call or visit your Rabobank Relationship Manager.

The information contained in this article is intended for general educational purposes only and is not to be construed as legal, tax, or financial advice. Please consult with your own legal, tax or financial advisor for guidance with your own particular circumstances.