Hedged with Derivatives, Variable-Rate Debt Gains Acceptance, Bond Panel Says
By Caitlin Jones & A. J. Johnson
5 min read
Tax Credit Advisor May, 2006: After years of skepticism from tax-credit investors, syndicators, and developers, short-term variable-rate debt, also known as “floaters,” is finally gaining acceptance. One of the main reasons for this, according to a panel of bond experts, is the growing use of derivatives to hedge floaters’ interest rate risk.
Interest-rate caps are the most widely used hedge in the affordable housing marketplace, according to the panel’s moderator, Tammy Ofek, a Senior Vice President at CDR Financial. Ofek joined a group of panelists to discuss the topic of derivatives at the National Housing & Rehabilitation’s 2006 Annual Meeting held last month in Miami Beach, Fla.
A cap, Ofek explained, hedges rate risk by setting a ceiling for the interest rate charged on a floater. The big advantage of caps, she noted, is that they are relatively inexpensive in today’s market. In addition, they do not require collateral, or, if terminated, breakage fees.
Over the past several years, developers have become more familiar with caps, and now often use them to hedge the interest-rate risk of variable-rate debt. Citing a recent example of the cost savings of using a floater with a cap during the construction period, Ofek said that after servicing fees were taken into account, the total interest rate charged for a $14 million floater was 5.08 percent, compared with 6.75 percent for a comparable fixed-rate loan. This interest rate differential of 1.67 percent a year netted the developer annual savings of $234,000.
Until recently, however, several issues have held developers back when they considered using caps to hedge variable-rate loans obtained as permanent financing over the entire 15-year tax-credit compliance period. For one thing, caps are much more expensive when offered for periods of more than five years. Secondly, banks have been reluctant to provide letters of credit for floaters that extend beyond five years. Thirdly, cap providers require that the entire fee for their product be paid up front.
Cap Innovations
Fortunately, these issues are now being resolved, said Ofek. Some banks have started offering open-ended letters of credit. A number of companies, including Fannie Mae and Freddie Mac, now have products that provide economical cap structures covering the entire 15-year tax-credit compliance period. In addition, financing for the cap fee payment is becoming available.
Fannie Mae’s product works by combining three separate five-year caps into a single 15-year cap, which is typically purchased at the closing of a permanent tax-credit property financing, explained Peter Coccaro, Director, Multifamily Affordable Housing. The cap works by “stepping up” the interest-rate strike price on the cap at five years, and then again at 10 years. A recent structure involves a cap at a 6 percent strike rate for the first five years, 6.5 percent for the second five, and 7.0 percent for the final five years.
One advantage of this product, said Coccaro, is that it permits borrowers to lock into historically low cap prices today. Another advantage is that the price of the cap tracks the amortization of the underlying loan, which allows Fannie to offer a less expensive cap fee for the second and third five-year periods.
Using Swaps Flexibility
Ofek said that providers of swaps – the second main type of derivative used to hedge floaters – have also adapted their product to better fit the needs of tax credit developers. In a swap, a variable-rate borrower exchanges loan payment streams with a fixed-rate borrower, or vice versa.
The most important advantage of a swap is that syndicators providing developers with Low Income Housing Tax Credit (LIHTC) equity are generally more willing to accept their use on a variable-rate loan than a cap. The upside of using a swap is limited, however, if interest rates remain low.
Swaps can be structured to take effect at some point in the future. This allows developers to enjoy the lower cost of a cap on the variable-rate debt during the construction period, and then to switch to the higher comfort level of a fixed rate during the tax-credit compliance period, she said.
The flexibility of swaps makes them ideal for use with “conduit” loans, borrowings derived from a pool of different bonds which have been combined into a single trust, said Jim Gillespie, Senior Vice President at New York-based Redstone Capital.
Derivatives and Risng Rates
John Rucker, Senior Vice President at Montgomery, Ala.-based Merchant Capital LLC, said that the adaptation of caps and swaps to the tax-credit marketplace has helped market participants become more comfortable with variable-rate debt.
Because of this, developers are likely to continue using floaters even if interest rates rise, Rucker said. This is particularly true of borrowers who use tax-exempt floaters in combination with 4 percent LIHTCs, he said, noting that the differential between long and short term tax-exempt rates remains substantial. Recent rates on tax-exempt triple-A rated, seven-day-demand variable-rate bonds were about 3.5 percent, while rates on 30-to-40-year tax-exempt AAA rated multifamily bonds were about 5.4 percent: a spread of about 200 basis points.
Because of the steep yield curve, “developers are realizing that it really pays to use lower floaters with caps or swaps,” said Rucker. “And also because of caps and swaps, equity investors and syndicators are getting more comfortable too.”
