Leveraging Hedging Tools to Stabilize Commercial Loans

At the beginning of this year, the futures market projected as many as five interest-rate cuts by the end of 2024. However, stronger-than-expected economic data has continued to emerge, causing market expectations for rate cuts to evolve. Although there has been a disparity between market expectations and Federal Reserve projections in months past, they are moving toward alignment, with year-end implied futures market Fed Funds rate currently at 4.93% and Federal Reserve estimate at 4.63%.

Using Interest-Rate Swaps for Commercial Borrower Lending

In the current interest-rate environment, credit unions involved in commercial lending may see a significant volume of loans resetting at higher rates in 2024 and 2025. This rate reset will stress borrowers’ cash flows and debt service coverage. Implementing a loan hedging strategy to mitigate interest-rate risk can prove invaluable in mitigating related credit stress. 

Loan hedging functions much like shock absorbers on a car—they help reduce volatility and limit the impact of sudden interest-rate changes. While hedging won't eliminate all risks, it can control them at a manageable cost and be applied to new and existing loans.

An interest-rate swap is a specific type of hedge that involves an agreement between two parties to exchange one stream of interest-rate payments for another over a defined period. Many financial institutions use swaps to convert the floating interest rate on a loan into a synthetic fixed rate for their commercial borrowers, while the credit union still receives floating-rate payments. 

Providing commercial borrowers with a fixed-rate structure enables them to make informed strategic budgets based on consistent payments throughout the loan's life. As the synthetic fixed rate for the borrower remains constant when market rates rise, the likelihood of payment defaults due to increasing interest expenses decreases. For the institution, maintaining a floating-rate loan helps manage interest-rate risk, better aligns with core funding sources, and stabilizes credit risk.

Forward Rate Lock Hedges: A Strategic Approach Using Interest-Rate Swaps

Credit unions don't want to issue more commercial real estate (CRE) loans if the quality is questionable. Similarly, CRE borrowers don’t want loans they can’t repay. Hedging with a forward rate lock (FRL) can make CRE borrowing more attractive for both parties involved in the transaction.

A forward rate lock is an agreement between a commercial borrower and a credit union to set a fixed rate for future financing. The FRL eliminates the risk of the borrower's rate changing before financing begins, while the hedge component (a forward-rate swap) ensures the institution’s loan pricing spread is preserved. FRLs are commonly used to fix rates on permanent financing following construction or to set future rates on existing resettable loans.

While the Federal Reserve continues to emphasize that rates will remain higher for longer, current market rate pricing for term financing creates opportunities for borrowers seeking the security of a fixed-rate loan. Given that bond market projections for future rate cuts are reflected in term rates today, forward-starting swap loan fixed rates are currently lower compared to standard spot rates. This dynamic is reflected in an inverted yield curve, where variable-rate loans (based on short-term indices) pay more than longer-term, fixed-rate loans. The market is ripe for borrowers and lenders to capitalize on this irregular trend.

Application of Forward Rate Locks

For instance, many credit unions are facing Net Interest Margin (NIM) compression from funding rate pressures on related low-yielding CRE loans, while a good number of CRE borrowers are facing cash flow stress as their loans reset into a “higher for longer” rate environment. 

A forward rate lock (FRL) with income-enhancing features can help increase current income on conventional commercial loans coming up for reset within the next 18 months. While the credit union is able to convert to a market-based rate immediately, the commercial borrower’s existing loan rate remains the same until the scheduled future reset date, at which point it converts to a fixed rate that is set today with an FRL. This approach also helps borrowers eliminate reset risk while giving them time to prepare for new payment amounts.

Benefits for Both Commercial Borrowers and Credit Unions

Here are three primary benefits of an FRL:

1. Eliminate future rate uncertainty: Using an FRL, the borrower sets their rate today, even though it’s not effective until the loan’s repricing date. This solution provides stability and predictability for financial planning.
2. Mitigate competitive refinancing threats: By locking in rates, borrowers are less likely to refinance with another institution, retaining business for the credit union.
3. Enhance income: Credit unions can immediately convert legacy loan rates to market basis to increase current interest income.

In conclusion, hedging is an essential tool for managing interest rate risk. Plus, forward rate locks offer a strategic advantage, enabling credit unions to enhance current income, offset NIM compression, and retain valuable commercial borrowers, while providing rate certainty and payment stability.

Femi Audifferen, SVP and Manager, Hedging Solutions, has over 23 years of banking, finance and capital markets experience. At PCBB, Femi is currently Senior Vice President and Manager of Hedging Solutions. In that role, he helps clients to strategize, structure and execute hedging solutions to mitigate interest rate risk. He also holds the Financial Risk Manager (FRM) designation, a globally recognized certification for financial risk managers.