Why would a lender require an interest rate swap or hedge?

The lender's reason

A floating-rate loan is priced as a base rate plus a spread; SOFR plus a spread explains the pricing. When the base rate rises, interest rises, and so does debt service. A lender that sized the loan on today's interest is exposed to a borrower whose coverage erodes for reasons that have nothing to do with how the business is run. The lender cannot stop rates rising. It can require the borrower to fix them.

The requirement is most common where the cushion is thinnest: acquisition loans with substantial debt relative to earnings, where a fixed charge coverage or debt service coverage covenant sits close to the level the deal produces at closing. Conventional bank lenders commonly look for debt service coverage of at least 1.25x. A deal that closes just above that has little room for higher interest; a hedge takes rate movements out of the test.

The hedge protects the lender's coverage test. It also protects the borrower from the same risk, which is why it is worth understanding rather than just signing.

How a swap works, in plain numbers

A swap is a contract between the borrower and a hedge counterparty, often the lender itself or an affiliate. It is based on a notional amount, usually matching the hedged part of the loan, that is never exchanged. On each payment date the borrower owes a fixed amount on the notional, the counterparty owes a floating amount on it, and only the difference changes hands. The borrower keeps paying the loan's floating interest as usual. The net result is that the base rate falls out of the borrower's cost.

Notice what the swap does not fix: the spread. If the loan has a pricing grid, the spread still moves with leverage. And if rates fall, the borrower does not benefit, because the swap payment rises to offset the lower loan interest. That is the price of certainty.

What the hedging covenant says

The requirement usually sits in the credit agreement as a post-closing covenant rather than a condition of closing. It sets how much of the term loan must be hedged, for how long, by when, and with whom. Each of those is negotiable before signing and hard to change after.

The last row causes more trouble than any other. If the loan amortizes and the swap notional does not, the borrower ends up hedging more than it owes, paying fixed on a notional larger than its loan. Match the swap's notional schedule to the loan's amortization.

How the swap is secured, and where it links to the loan

A swap is a separate contract, usually a master agreement plus a confirmation for the specific trade, but it is tied to the loan in three ways. First, swap obligations owed to the lender or an approved counterparty are typically secured by the same collateral as the loan, and rank equally with it; pari passu explains what that means. Second, a default under the swap is usually a default under the loan, and the reverse; that is a cross-default. Third, a counterparty's exposure to the borrower under the swap uses up credit the lender might otherwise extend.

Watch for one mismatch. Many floating-rate loans have an interest rate floor, a minimum base rate. If the loan has a floor and the swap does not, then in a very low-rate environment the borrower pays the floor on the loan while still paying fixed on the swap and receiving almost nothing. Ask for the swap's floating leg to carry the same floor as the loan.

Breakage: what it costs to leave early

A swap has a market value that moves as rates move. If rates fall after you sign, the fixed rate you locked in is above market, and the swap has negative value to you. If you then repay the loan early, through a refinancing or a sale of the business, the swap must be ended too, and ending it means paying its negative value to the counterparty. That payment is breakage, and on a long swap after a meaningful rate decline it can be large.

It works the other way as well. If rates have risen since you signed, the swap has positive value to you, and ending it may produce a payment to you. Breakage is a settlement of the swap's value, not a penalty. But because it is unknown until the day you end the swap, it should be treated as a risk in any plan that involves refinancing or selling before the swap matures. Prepayment penalties and call protection covers the loan's own exit costs, which come on top.

• Keep the swap's tenor no longer than you expect to hold the loan.
• Ask the counterparty to show how breakage would be calculated before you sign.
• Include expected breakage in any refinancing or sale analysis while rates are below your fixed rate.

When a cap is the better tool

A rate cap pays the borrower when the base rate rises above an agreed level, in exchange for a premium paid upfront. Below the cap, the borrower keeps the benefit of falling rates, and there is no breakage: at worst the unused premium is lost. A cap suits a borrower that expects to refinance or sell within a few years, or that wants protection against a large rise without giving up the benefit of a fall. A swap suits a borrower that will hold the loan through the hedge's term and wants the lowest fixed cost. Swap vs cap compares the two in full, and fixed vs variable rate covers taking a fixed-rate loan instead.

Transparent's financing model tests coverage at today's rates and under higher-rate scenarios, hedged and unhedged, so the hedging covenant can be sized to what the deal actually needs rather than to a lender's default. When lenders require a hedge covers which deals draw the requirement.