Hedging Interest Rate Risk

I have a new client who recently bought a Veterinary Clinic. The total loan is approximately 700k on a 10 year term. It is a variable rate based on 1 month LIBOR (currently at 0.35) plus a spread (4.5 I think) with no cap. His largest asset is his human capital by far. Therefore, the biggest risk I see to his goals are losing his future income stream. This can be insured to a certain extent. The next biggest threat is a rise in the interest rate on his loan which could increase an already pretty hefty mortgage payment. What are some options to hedge his interest rate risk that would be available to an individual? Pros and Cons?

Swaps? Hookers? Bribes? Refi? Maybe negotiate the debt to have it capped? Taking an uncapped loan seems pretty risky to me, then again starting a vet clinic seems risky as well. I heard that the household pet industry runs something like 10 - 15 bln /year in revenue

Swaps are an obvious choice, but it is hard to get a swap negotiated for an individual (as far as I know). IR options would be another choice but I don’t know how to get access to them. I am a partner in a small RIA that works with individuals and this is not a common technique to our firm.

MWVT9 - Who is your broker? They should be able to povide access to IR futures/options. If not, there are retail brokers that can help with this (i.e. Interactive Brokers, Etrade, etc.). HTH.

LPoulin133 Wrote: ------------------------------------------------------- > MWVT9 - Who is your broker? They should be able > to povide access to IR futures/options. If not, > there are retail brokers that can help with this > (i.e. Interactive Brokers, Etrade, etc.). HTH. Our firm trades though the Institutional side of TD Ameritrade. I was on the phone with them when I got your post. I can’t seem to get to a person who even knows what IR futures or IR option or swaps are at this point. Someone is supposed to call me back.

What about allocating some capital to leveraged loans via buying a leveraged loan closed end fund? I know this is a crude way to hedge a specifc IR risk but if/when IR rise, the rates these loans pay should rise as well. Plus, it’s probably easier to implement for a retail investor / small buisness owner than buying IR options or swaps.

pay fixed recieve libor swap. i think it is cheaper than forwards since you are not rolling over contracts.

can you get a hedge for such a small notional amount? You’ll probably get raked on the fee to set it up. An interest rate collar may offset the cost. I wonder if you could pay a floor above the current rate. in that case maybe you could make it costless. How much do rates have to go up to make his DSCR dangerously low? Is it a C&I loan or a mortgage? If a mortgage, you might be able to just refi to fixed.

jbaldyga Wrote: ------------------------------------------------------- > can you get a hedge for such a small notional > amount? You’ll probably get raked on the fee to > set it up. An interest rate collar may offset the > cost. I wonder if you could pay a floor above the > current rate. in that case maybe you could make > it costless. > > How much do rates have to go up to make his DSCR > dangerously low? Is it a C&I loan or a mortgage? > If a mortgage, you might be able to just refi to > fixed. I was looking to see the cost of the swap or cap with options vs the cost to refi. I haven’t been able to get to much help yet.

Funny, I am in a similar situation. I took out a 5/1 ARM on my home 6 years ago. When the refi date came closer, I took a look at the mortgage document and came to find out that the reset rate is 1 year LIBOR + 225. Well, at the time I was investigating this, the 1 yr LIBOR was ~1.5% (historic lows). I ended up resetting at like 1.5 + 2.25 or something. Now my reset is due up again and I’m sensing that I’m not going to get many more opportunities to reset at low rates. I will probably pass this time, but not again. So I’m looking for a way do something similar - so mwvt9 - if you find something - let me know.

The problem with hedging an increase in rates is that everyone expects a fairly significant increase in rates. In other words, your insight is hardly unique, so you will pay very dearly to be protected against a worst case scenario. Insurance against higher future rates will not be cheap.

dlpicket Wrote: ------------------------------------------------------- > The problem with hedging an increase in rates is > that everyone expects a fairly significant > increase in rates. In other words, your insight is > hardly unique, so you will pay very dearly to be > protected against a worst case scenario. Insurance > against higher future rates will not be cheap. I have no insight and I don’t put much faith in forecasts. If rates don’t go up he doesn’t get hurt. If they do go up he does. It is that simple. I agree that it probably won’t be cheap.

CPierce, in your case you should probably be locking longer fixed rates; assuming the amount of time you’re spending in the house makes sense. I just locked 4.875 (having just missed 4.75) for 30 year fixed. As for mwvt9, I don’t think heding is likely the right decision due to size of loan. Did the try to secure fixed rate unsuccessfully? Seems like a commercial lender should be able to look at the revenue stream and underwrite because it sounds like he bought an existing business.

Sponge_Bob_CFA Wrote: ------------------------------------------------------- > As for mwvt9, I don’t think heding is likely the > right decision due to size of loan. Did the try > to secure fixed rate unsuccessfully? Seems like a > commercial lender should be able to look at the > revenue stream and underwrite because it sounds > like he bought an existing business. Haven’t tried to fix it yet. I don’t even think it occurred to him since LIBOR has been dropping since inception. This loan was backed by the SBA and I am not sure of his refinancing options at this point. I will have to investigate further.

I would assume SBA would be all for locking longer fixed, as it removes the risk of IR…then again SBA is probably top of the pecking order, so won’t care as much.

Just talked with someone. I will let you know (just in case anybody is interested).