Whether borrowing or lending, virtually every prospective market participant confronts the choice between fixed-rate financing or variable-rate financing. And the way the world typically works today, practitioners are forced to pick one or the other. Given the opportunity, however, a large population of players would likely opt for a middle ground. That is, rather than committing to a fully fixed-rate instrument or a fully variable-rate instrument, a “half-and-half structure” would be an attractive alternative. Moreover, once that door is open, it should be clear that virtually any mix of fixed and floating (e.g., 25 percent fixed-rate and 75 percent floating rate, or vice versa) would be possible. Such a mixed-rate construct is easily engineered with the use of interest rate swaps.
To illustrate the idea more concretely, consider the issue from the perspective of the banker who wants to arrange a half-and-half loan (i.e., half fixed-rate; half variable-rate) for a prospective borrower. The banker could satisfy this borrower in a number of ways:
- The banker could structure the loan where the interest payment is calculated as if the loan were a combination of two loans, each for 50 percent of the desired principal amount. One component would base its contribution to interest expense on a stipulated fixed-interest rate, while the interest rate on from the second component would be reset periodically, based on an observable variable interest rate (e.g., LIBOR).
- The banker could offer variable-rate financing and simultaneously enter into an interest rate swap with the borrower, where the notional of the swap is half of the principal on the loan, and the bank customer (i.e., the borrower) pays fixed and receives variable on the swap.
- The banker could offer fixed-rate financing and simultaneously structure a different interest rate swap with the borrower. As with the prior swap, the notional of this swap would be half of the principal on the loan; but in this case the borrower pays variable and receives fixed on the swap.
To the extent that the bank preferred to avoid bearing the swaps’ exposures in these last two alternatives, the bank could easily offset that risk by entering into offsetting swaps with a third party – i.e., a different swap dealer. More likely than not, these back-to-back swaps would have identical accrual periods and settlement dates, a common floating interest rate, but the two fixed interest rates would likely be slightly different, allowing the bank to realize incremental income through the lives of the swaps, commensurate with the difference between the two fixed interest rates.
All of three of these designs listed above result in cash flows that mimic those of the half-and-half loan structure; but the accounting differs under each of these designs and, potentially, the company’s resulting reported earnings could differ, as well.
From the borrower’s perspective, the first design would undoubtedly be the easiest. In this case, barring application of the fair value option, the loan would be carried on the balance sheet of both the bank and the customer at its outstanding principal value, and the interest revenue/expense would simply be the combined interest settlements of the two components of the loan. With such a loan design, the bank might (or might not) opt to use derivatives to over-ride the original debt’s duration and interest rate exposures, but the bank’s action in this regard would be totally irrelevant from the perspective of the borrower.
The second alternative design permits two different accounting treatments: a) cash flow hedge accounting or (b) no special hedge accounting treatment (i.e., regular derivatives accounting). Hedge accounting’s appeal is that it allows the economics of the hedge – or a close approximation — to be transparently represented in the company’s income statement. This presentation is likely to be important to public companies, but less so for privately-held firms. That is, private companies might not care all that much about reported income, as long as the hedge construction results in the desired cash flows. Those cashflows, however, would be determined by the way the hedge is constructed, which is totally separate and apart from any accounting considerations. Firms thus have the discretion to apply hedge accounting or not, balancing the seemingly improved income statement presentation with the perceived hassle of qualifying for that treatment. Importantly, qualifying for hedge accounting isn’t trivial, but it’s do-able.
With cash flow hedge accounting, a perfectly constructed hedge would generate reported interest expense in an amount that would be identical to that reported under the first design, but the borrower would also record unrealized hedge gains or losses in other comprehensive income. Without this hedge accounting treatment (i.e., regular derivatives accounting), both the swap settlements and the swap’s mark-to-market gains or losses (i.e., unrealized swap results) would be recorded in the company’s reported earnings, most likely as interest expense. These two alternative earnings outcomes — with hedge accounting versus without — would likely be dramatically different.
While the borrower under this second funding strategy starts with floating-rate debt and then swaps half of that debt to fixed, the borrower employing the third design starts with fixed-rate borrowing and then swaps half of that fixed-rate debt to floating. The second and third designs are sort of reverse images of each other. The same ultimate cash flows occur, but once again, the accounting is distinct. As with the second alternative, the borrowing entity can apply hedge accounting, or not; but in this case, the hedge accounting would be fair value hedge accounting, as opposed to cash flow hedge accounting.
Whereas cash flow hedge accounting generally defers unrealized hedge gains or losses, with fair value hedging these unrealized results are reported in earnings; but fair value hedging also requires the carrying values of the fixed rate debt being hedged to be adjusted to reflect the price effects of the risk being hedged, with the changes in the carrying values reflected in current income. In a perfect world, the unrealized swap results and the debt’s carrying value adjustment would be largely offsetting, in such a way as to replicate the earnings outcome of the first design. This outcome happens to be assured if shortcut hedge accounting is applied, but this treatment, though permitted by GAAP, is frequently discouraged by auditing firms. Without reliance on the shortcut methods, firms may still apply what has become known as the long haul fair value method; but this method will likely result in realizing some measure of ineffective earnings – a prospect that probably makes this last design the least attractive of the three, unless the reported earnings impact is of little concern.
[For a more detailed discussion of the various accounting treatments for derivatives, see http://www.kawaller.com/accounting-treatments/.]
As a final consideration, it’s worth pointing out that whenever either party of the financing has the capacity to terminate prior to the natural maturity, the appropriate hedge might not be quite as obvious as it is when these options aren’t present. Still, even with loan early-termination provisions, bankers would be able to engineer a variety of hedge constructions that would foster a mix of fixed and floating rate interest payments. Some such hedges might end up generating fixed versus floating rate proportions in the financing that might not be entirely predictable or consistent throughout the terms of the loans, but the hedge would nonetheless offer an alternative to the extreme of the fully fixed- or fully floating-financing alternatives; and in all likelihood, these hybrid designs would be preferred by at least some portion of commercial borrowers.