Minimizing risk when interest rates are on the rise.

Businesses are always working to manage interest rate risk. Given recent trends, now could be a good time to lock in low fixed rates as protection from potentially higher rates down the road. Which tools are best, and how do they work?

Switch Rates in a Swap

Swaps allow companies to restructure the interest rate profile of their debt without restructuring their loan. In implementing a swap, floating interest payments are exchanged for fixed payments at an agreed upon rate for the duration of the agreement. If a company wants to take advantage of today's lowest rates, they go variable. If they prefer to pay a higher rate in exchange for protection from increasing interest rates, a swap can be a smart move.

All example is one Comerica customer with a seven-year, variable-rate property loan based on LIBOR (London Interbank Offered Rate). Seeing LIBOR rates rise almost a full percent between December 2004 and June 2005, the company asked the bank about other options. An environment in which short-term rates are rising and long-term rates are flattening is ideal for a swap, and that's what Comerica proposed. The customer swapped the variable rate for a fixed rate of 6.39% for four years, a period for which they are certain they will own the property. After four years, they can do another swap or allow the rate to go back to the prevailing variable rate.

Another customer with $12 million in variable-rate loans with Comerica and another financial institution was concerned about rising rates, and asked Comerica for some options. The other institution didn't offer favorable fixed-term options, so Comerica helped them hedge half of their position by structuring three swaps totaling $6 million (each with a slightly different fixed rate and term). The customer didn't want to risk putting all of their eggs in one basket and potentially make the wrong decision. Hedging half allowed them to see an upside whether rates go up or clown, and experience the best of both worlds. If rates go up, they'll be happy that half of their loans have fixed rates. If rates go down, part of their loan portfolio will benefit from the floating rate.

Capitalize on a Cap

Caps are also useful now as insurance against rising rates, especially if you think rates will stay low for a while longer and don't want to fix your rate with a swap. Borrowing at a floating rate while simultaneously buying an interest rate cap protects you against higher rates while maintaining the benefit of current low rates. You designate the highest interest rate to be paid over the loan period.

One Comerica customer wanted real estate financing that would provide interest rate protection with no prepayment penalty. A cap provides that guarantee. With a cap, as opposed to a conventional fixed rate loan, the customer gets the benefit of the current lower variable interest rate market with a limit on how high their rate can move. The customer bought a cap at 6.1% for six years of their eight year loan period. Their loan balance will be low enough in the last two years so that they can either pay off the loan or not be significantly affected by interest rate movement. Another potential benefit to a cap; if you pay off the loan, you no longer need the cap, and there is no cost to terminate it. There may also be some residual market value to the cap, for which Comerica would offer a cash payment.

Forget Floors and Collars in the Current Climate

Selling a floor limits the downside movement in interest rates on floating rate debt. When you sell a floor, you receive a fee. Floors are not a beneficial option in the current environment. An interest rate collar involves buying a cap while simultaneously selling a floor to offset part or all of the cap premium. If values of the cap and floor are the same at inception, that creates a no-cost collar because their respective costs offset each other. Collars typically make sense when shortand long-term rates are very close to each other.

Let Us Help You Put the Tools to Work

One final example: companies that may not be able to raise revenues easily if rates rise should look at hedging. For instance, if a 2.0% rise in interest rates wouldn't affect your business, but a 4.0% rise would be a problem, you could buy a cap, or fix a portion of the debt with a swap so that you're not totally exposed. These are all relatively simple examples of what can be very complex finance structures. Your use of interest rate risk management tools depends on many factors, such as expectations for future cash flow, debt paydown, and possible new financing needs. That said, any business with exposure to floating rate debt, and especially companies needing to closely manage their cash flow, can benefit from interest rate risk-management tools. Comerica can help you evaluate your interest rate risk and spell out your options. We're also flexible about how we apply these interest rate hedging products; for instance, by allowing you to cap or swap all or a portion (minimum $1 million) or term of your loan for up to 10 years and by customizing your solution based on your financing needs.

INTEREST RATE CAP

* Customer buys interest rate protection from rising rates by setting a limit to how high they want their rate to go

* Up-front fee

* Provides a maximum interest rate while allowing customer to enjoy current low rates

* Separate transaction from the loan

* No payment required to get out of a cap

* Potential market value gain if rates rise (cash value when terminated)

INTEREST RATE SWAP 

* A contract to exchange interest pay ments, which converts a floating rate loan to a fixed rate loan or vice versa 

* No up-front fee

* Less expensive to terminate than a fixed rate loan (saves margin component of prepayment premium)

* Separate transaction from the loan

* Potential market value gain if rates rise (cash value when terminated)

Ray Boyadjian is Senior Vice President of Comerca's San Fernando Valley Middle Market Office. For more information, please call him directly at [phone].