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Hedging Future Bond Issuance With a Rate Lock
One of the most effective and cost efficient ways to lock in
current low interest rates is to utilize a "Rate Lock." The
Rate Lock allows a bond issuer to lock in rates based on
the MMD index, US treasuries or another long-term index.
This insurance against rising rates is simple to execute
and, since the termination price (at the end of the Rate
Lock), is based on readily available market indices, simple
to value. MMD based Rate Locks are economical to 12 months,
U.S. Treasury Rate Locks to five years.
A Rate Lock is initially priced as a yield and terminated with
a cash payment. There is no payment made or received at inception.
The yield quoted will be slightly higher than the current rate
for the given index. On the date the Rate Lock is terminated, the
bond issuer will make a payment if the index is lower than the
locked in rate, they will receive a payment if the index is higher
than the locked in rate.
By utilizing a Rate Lock, a bond issuer can lock in their total
debt service at today's rates, plus a slight margin. If, on the
termination date, the bond issuer makes a payment (rates are lower
than the locked in rate) they simply issue more bonds but at lower
rates. If the bond issuer receives a payment, they will issue fewer
bonds but with higher coupons. The bond issuer does bear the risk
that their cost of funds does not move exactly in tandem with the
index rate.
Rate Locks have two primary benefits over interest rate swaps
for hedging future interest rate risk associated with a future
bond issuance. First, the termination cost is easy to calculate
based on published indexes or widely traded instruments. Second,
the bond issuer can lock in a long-term index, more analogous to
the bonds to be issued. Swaps generally involve a short-term (LIBOR,
BMA) floating rate, which exposes bond issuers to changes in the
steepness of the yield curve. The disadvantage of a Rate Lock is
that they become expensive past 10 months for tax-exempt indices,
5 years for treasury based.
The amount and term of the Rate Lock purchased should be carefully
evaluated and tailored to correctly match the bond issuers projected
debt service and risk tolerance. For instance, a bond issuer that
is primarily concerned with exposure to the absolute level of interest
rates; a Treasury Rate Lock may be a good option. For an issuer
of tax-exempt bonds, an MMD Rate Lock may be a good choice to protect
against increases in interest rates and the risk that tax-exempt
rates do not closely track general market interest rates (basis
risk).
The expiration date of the Rate Lock is determined at the inception
of the Rate Lock, which is the last possible date that the Rate
Lock can be terminated. However, the bond issuer is not required
to keep the lock in place until the expiration date, they may choose
to terminate early, and make or receive a payment based on the
then current index rate.
A Rate Lock has advantages over other hedging instruments:
- Ease
of documentation, based on ISDA master swap
- Easy to value
based on publicly available index
- Variety of long-term indexes
available to closely match prospective debt
- Can be terminated
prior to expiration, which provides additional transaction
flexibility to bond issuer
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