The option represents a strong choice in a volatile climate, analyst says
Interest rate volatility and economic uncertainty show little sign of easing in Canada – and in that climate, the commercial lending space is seeing an upsurge in interest in a financial derivative aimed at hedging and managing rate risk, according to a prominent executive in the sector.
Joey Tai (pictured, top right), principal at the Vancouver-based financial advisory and placement services firm Crete Capital, told Canadian Mortgage Professional that so-called interest rate swaps were proving increasingly popular among certain commercial borrowers and lenders as a means of mitigating the prospect of rate increases or drops, particularly for future financing.
Where clients are unable to lock into a rate until they close on a development project that’s not expected to complete construction until well down the line, such arrangements have proven a strong option, according to Tai.
That derivative type amounts to a contract between two parties to exchange a series of interest rate payments on a specific principal amount, with the borrower paying a fixed rate in an arrangement that nets out the fluctuations in the market.
“So if you’ve agreed to pay a fixed rate for, say, two or three years or whatever it may be, these are all customizable,” Tai said. “And [if] interest rates end up going up, that means you’d be in the money, and the other party will be paying you the net difference.
“However, if you’ve agreed to a fixed rate and the market goes down, you actually have to pay for the difference, the net costs. But the end result is that you’re [locked] into a fixed rate.”
Why are interest rate swaps so popular in the commercial market at present?
The product is by no means a recent invention – but has proven especially well suited to the current climate, Tai said, with little clarity over where interest rates will end up down the line and much uncertainty still hovering over the Canadian economy.
Chase Belair, Co-founder of the nesto digital brokerage noted that Canada’s chronic lack of #housing supply and continued demand are likely to keep the market ticking along even in the event of a further rate jump this week.https://t.co/LBtxVGEtep#ratehike #interestrates
— Canadian Mortgage Professional Magazine (@CMPmagazine) July 10, 2023
“It’s a product that has been around for a long time. It just hasn’t gotten a lot of attention because interest rate volatility hasn’t been as much of a concern as it is today. Uncertainty hasn’t been as prevalent as it is today,” Tai said.
“So although this product has been around for a long time, we haven’t had as many inquiries and discussions around hedging and management of interest rate exposure as we have today – and that’s why we’re bringing this product forward. It’s almost like an insurance policy on interest rates.”
Which borrower types are interest rate swaps most suitable for?
The product is an attractive one for lenders because it gives them a competitive advantage in winning business, and helps generate revenue for commercial banks through a small premium applied to their selling rate.
For borrowers, meanwhile, it offers a degree of certainty about interest rates when they could fluctuate dramatically in the coming years – although Tai emphasized that it’s most suitable for lower mid-market businesses borrowing $5 million or more with a dedicated vice president for finance or chief financial offer that can administer the contract.
“Part of our job is helping explaining [and] elucidating the sophisticated and straight hedging tools into simple-to-understand strategies, [but] we still need our clients to be able to administrate the ongoing requirements of it,” he said.
“And so in terms of a fit, it is suited for slightly more sophisticated borrowers, although it’s not that hard to understand. But for the owner-operators, small business, it’s not something that we would recommend.”
As for the likely long-term popularity of those types of product? Tai said that while they may remain a solid option for certain borrowers, their current suitability is tied in large part to the instability at play in today’s market.
“I think if the market stabilizes, and the sentiment is that rates are going to stay or go down… there’s going to be less curiosity or motivation to get into these contracts,” he said.
“But certainly in the environment we’re in right now, our clients are going to be much more comfortable and happy paying an extra 10 to 20 basis points knowing that they don’t have to worry about rates doubling or tripling on them like [they have] in the past 12 months.
“That puts their business and their long-term investment at risk, rather than paying a little bit more or committing to a little bit more of a premium today.”
