Interest rate caps vs. swaps: weighing the alternatives

Product fundamentals

At a high level, interest rate caps are option products that require a premium and create a synthetic upper limit for the rate on your floating-rate debt. Swaps, on the other hand, allow you to synthetically fix your floating rate at a specific level based on the current forward curve. Because of the fundamental differences between the products, there are a few key factors that drive corporate decision-making across all market environments:

• Cash availability: Caps require an upfront premium payment, so swaps are generally preferable for companies who don’t want an immediate cash outlay.
• Preserving upside: Swaps lock you in at a fixed rate, meaning you will no longer benefit if rates fall more than expected in the future. If you instead buy a cap, you will be able to take full advantage of falling rates (at the cost of your upfront premium payment).
• Level of protection desired: Caps can be ideal for companies that are just looking for protection against extreme, worst-case scenarios, while swaps are ideal for those who want to achieve certainty and protect against even minor rate movements.
• Creditworthiness: Swaps are credit-intensive, as they can become large liabilities over time. As a result, caps are often preferable for corporates with poor credit or limited counterparty relationships.

The role of the interest rate environment

When it comes to market factors, interest rate volatility and the shape of the forward curve are two key inputs to the caps vs. swaps debate. The role of volatility is somewhat straightforward, as high volatility will generally increase cap premiums, making it more expensive for corporates to preserve upside. Swaps, on the other hand, can be ideal in high-volatility periods because they allow you to lock in at the current forward curve without an additional cost. It’s also worth noting that execution fees may be elevated for both products in times of high volatility.

When it comes to the shape of the forward curve, the implications for instrument choice are a bit more nuanced. In the next section, we’ll run through a few common interest rate environments and consider their respective impacts on hedging product choice.

Downward-sloping forward curve (Example: Q2 2023)

When rates are expected to fall soon, swaps gain a unique benefit when you consider expected payments in the short to medium term. In this scenario, the fixed rate you lock in on your swap will be lower than current floating-rate fixings, meaning you’ll see an immediate reduction in the size of your interest rate payments. This can be especially helpful if your company is experiencing headwinds and looking to preserve cash in the short term.

As for caps, the downward-sloping curve will mean that companies can set cap strikes at or around current fixing levels without facing extremely high premiums. This can be attractive for companies who are comfortable with their current interest expense as a worst-case and would like to take advantage of the upside if rates fall.

Upward-sloping forward curve (Example: Q1 2022)

An upward-sloping curve often leaves companies feeling that neither product achieves exactly what they’re looking for, as the expectation of higher rates will already be baked into both swap rates and cap premiums. With that said, this is arguably the most important time to lock in protection, and the two products achieve that in slightly different ways. Swap rates will be fixed above current floating-rate fixings, meaning companies who use them will likely see a jump in interest payments in the short term. But they provide valuable certainty around expected future interest expense by locking-in a rate.

Companies who pursue caps in upward-sloping environments are typically looking for disaster protection — i.e., protection in case the forward curve steepens even further — as premiums at lower strikes will be costly.

Near-zero rates (Example: Q2 2020)

One unique consideration in near-zero rate environments relates to the role of interest rate floors. When rates are near zero, companies with floors in their underlying credit agreements often need to embed floors in their swaps to qualify for hedge accounting. But because floors are so expensive in these conditions, the all-in swap rates companies can achieve become much less attractive (e.g., the fixed rate on a swap with an embedded 1% floor will always be above 1%).

As a result, some corporates will explore using caps to mitigate risk without paying for embedded floors. However, in some ways, this distinction is only psychological. If you have a 1% floor on your debt, you won’t be able to access the upside below that level, regardless of whether you use a swap or cap. And if you can lock in a swap (with an embedded floor) at a fixed rate just above 1%, the window for cap upside participation is actually very limited, because your debt service has already reached its lower bound.

When rates get close to zero, we often advise companies on whether embedding floors is necessary by modeling potential rate movements and the resulting impact on hedge accounting effectiveness.

Additional considerations

The above provides a high-level overview of the respective advantages of interest rate caps and swaps across different market environments, but there are often more nuanced elements that come into play. Determining the appropriate financial instrument for you depends not only on the structure of the instrument and the current market environment but also on your organization’s unique objectives. Schedule a conversation with a Chatham advisor for support in achieving the most effective strategy and pricing.