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You can enter a forward swap to eliminate interest rate risk, but the spread risk still exists when the swap actually goes into effect. My goal is to convert a floating rate credit facility that will be funded at a future date into a fixed rate facility.

For example, suppose I take a loan today with a bank for $200mm at 1-Month Libor + 180bps (the "spread"), I can immediately enter into a swap paying 120bps and receiving 1-Month Libor, for an effective rate of 300bps.

Taking this one step further, suppose I enter into a forward swap that begins in 2020 at the same rate, paying 120bps and receiving 1-Month Libor. The only exposure I have left is the spread (The collateral is strong so I'm making the assumption there is no risk to funding the bank loan/credit facility at that time).

I'm not aware of any instrument I can use to eliminate or hedge the spread risk, and no lender (that I know of) will commit to locking in a spread at a future date. Is it possible to hedge this risk?

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  • $\begingroup$ With spread risk, do you mean the risk that you have to pay a higher spread on a loan that you will contract at some point in the future? i.e. an increase of your own credit spread? $\endgroup$ – Ami44 Jan 27 '17 at 16:53
  • $\begingroup$ @ami44 Precisely. If the spread goes from 180bps today to 350bps when it comes time to execute the other side of the transaction (fund the credit facility). $\endgroup$ – jeff m Jan 28 '17 at 17:14
  • $\begingroup$ Just an idea: the greater part of this spread variability comes out of the credit-spread, right? If you hedge against your collateral loosing value, you might have hedged against a big part of your spread risk. If that is reasonably possible depends on your type of collateral. $\endgroup$ – Ami44 Jan 30 '17 at 7:13
  • $\begingroup$ While the collateral can lose value, the portfolio is already low leverage (<40% LTV), so credit quality shouldn't be a large component of the spread. $\endgroup$ – jeff m Jan 30 '17 at 15:09
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You can take out a loan for the whole time from now until the end of the forward period, except that from now until 2020 the loan is unfunded, so you just pay an annual commitment fee. Banks should be willing to commit to a spread on this arrangement.

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  • $\begingroup$ That's a good idea, but has a few drawbacks (which may not outweigh the benefits). The lender's I've spoken to so far have only appetite for 4-5 years (with possibly 1 extension option), and the debt I'm looking to refinance matures in late 2019/2020. The unused commitment fees are around 35-45bps, so I'd be looking at a couple million dollar in fees that would otherwise be distributed to the partners by structuring it like this. I like this approach just for the fact I can price what it will cost to remove interest rate risk though. $\endgroup$ – jeff m Jan 28 '17 at 17:30

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