Caps and floors can protect you from soaring rates

Like a lot of chief financial officers, Tom Seale had his suspicions about hedging the interest costs of the debt of Buford Television Inc., a midsize, 80,000-subscriber cable-television company based in Tyler, Tex. When he heard about caps and collars, he assumed they were techniques for gambling in the financial market. Now, however, he's the proud owner of "costless collars" on roughly 75% of the company's debt. "This is a slick deal," he exults.

It's also the kind of deal that much smaller companies can and should use. As Seale learned, those hedging techniques are actually antispeculative. They provide a way to nail down interest-rate costs, whereas living with a floating-rate loan subjects you to complete uncertainty. The interest cost of your loan could go sky-high if prevailing interest rates soar.

Of course, there's been seemingly little reason to worry about that during recent years. We haven't experienced lately the kind of hair-raising interest-rate spike that moved the prime from 11% in late 1980 to 21½% in 1981. But that may change. Inflation began creeping back into the government's indexes even before oil prices shot up as a result of the Middle East crisis. A strong inflationary trend -- not to mention further disruption overseas -- could portend significantly higher rates.

On the other hand, the country also seems likely to have a recession, the first one since 1982. That, of course, would encourage the Federal Reserve Board to relax its grip on credit and nudge interest rates down.

The point is this: interest rates probably are going to make a significant move one way or the other. Now is the time to figure out how badly higher interest rates might sting and to protect yourself against them. John Lange, the National Westminster Bank USA vice-president who helped Buford Television implement a costless collar, says that few midsize companies understand hedging techniques. Most of the time, business owners "have never heard of these products. They're usually absolutely amazed," says Lange. Although many banks won't sell an interest-rate cap on debts of less than $5 million, some banks -- like NatWest USA, as Lange's bank is called -- will help you hedge as little as $1 million in debt.

A collar consists of two parts: an interest-rate cap and an interest-rate floor. Each of them can be bought (or sold) separately. But when they're combined, they form brackets on either side of your current interest-rate expenses, guaranteeing that those costs will go no higher than X and no lower than Y.

Let's start with the cap portion of Buford Television's collar. The interest rate on the company's debt floats according to LIBOR (London Interbank Offered Rate), the interest rate at which banks lend funds to one another, and is reset every three months. Buford pays LIBOR plus an agreed-upon percentage that represents the borrowing spread on which NatWest makes its money. When Buford negotiated its collar, early this year, LIBOR was at 85/16%. Seale decided that the company could live with higher rates -- up to 10%, plus the spread -- so that's where he set the cap. So, if rates rise to 9½% or 10%, Buford pays the higher interest costs. But if LIBOR rises above 10%, he pays no more than 10%, plus the spread.

Such protection isn't free. If Seale had stopped here, NatWest would have charged the company a little less than 1% of the loan amount for the two-year cap. But he decided to offset the cap with its mirror image -- an interest-rate floor.

Just as a cap restricts how high your interest rate can rise, a floor limits how low it can fall. Because it constitutes a promise to pay a certain interest rate even if overall rates fall far below it, a floor is valuable to a lender.

So Seale asked NatWest to pick an interest-rate floor whose value would equal the cost of the 10% cap. NatWest's pricing of caps and floors is influenced by prevailing interest rates in the financial markets, competitor's prices, and its own portfolio of assets and liabilities. During the period that Seale was negotiating his floor, it turned out that a 77/10% floor would offset the cost of his 10% cap. That floor means that even if interest rates fall to 5%, Seale will be stuck paying 77/10%, plus the borrowing spread.

But now he has two years of protection against a disastrous interest-rate spike, and two years of certainty. The first amounts to insurance against calamity; it's something you may not need but don't want to be without. But the second, certainty, may be even more valuable. Seale has actually collared his interest costs. As a result, he can more accurately forecast how the company will perform under different economic and sales scenarios. Naturally, that makes Buford Television better equipped to face whatever happens.

The timing of the installation of a collar will determine whether or not it ends up being cost-free, as Seale's collar did. What you are looking for, ideally, is an inverted yield curve. This convoluted-sounding creature is nothing more than a situation in which long-term interest rates are lower than short-term interest rates. The normal state of affairs is the other way around. However, these days, the abnormal often prevails.

For example, from March 1989 to midway through the year, the yield curve was inverted. "That meant that even after taking all factors into account, the value of floors was rather high compared with the cost of a cap," explains John Lange. "In that situation it is very easy to write a negative-cost collar." In other words, the bank pays you for the collar.

In July 1989, for example, NatWest constructed a five-year collar on $25 million in debt for another customer. The prime was at 10½%, the cap was set at 12%, and the floor was set at 10%. Not only did the customer get to hedge his interest costs, he received a onetime fee -- $250,000. That's how much more the market valued his floor than his cap.

Even when the yield curve is sloping the way it usually does, it's possible to write a costless collar. It all depends on where you set the floor and cap.

For example, in September 1990, when the yield curve reflected expectations of higher rates in the future, NatWest could have created a collar on 10% debt that worked this way: the cap on a $3-million loan would be 11% for three years. To pay for it, a floor would have been set just under the base rate of 10% -- at 94/5%.

Because a collar is an independent transaction, not one that is tied to a specific loan, it's flexible. You can decide to hedge all of your debt, even if it consists of several loans, or you can hedge 75% of a single floating-rate debt. What's more, you're not tied to the bank that made the loan to you, either.

Lange says that most midsize companies tend to let tradition guide them when it comes to borrowing money -- going for fixed-rate debt, for example, because that's how the company has always borrowed. But that tactic may not make sense in a high-interest-rate environment. The real beauty of hedging techniques is that you can actually rethink your approach to the debt that you already have, instead of waiting until you borrow anew. Hedging techniques allow you to decide what you can live with and what you can't.


How to make hedging pay

March 1989 June 1990

Cap 12% 12%

Current (prime) rate 11.5 10

Floor 10.9 9.75

* Cap: the highest rate affecting the rate you'll pay on your floating-rate debt

* Current (Prime) Rate: the rate in effect when the collar is negotiated

* Floor: the lowest rate affecting the rate you'll pay on your floating-rate debt

Cost-free collars are constructed differently, depending on the current economic environment. The left column is a five-year collar that could have been constructed in March 1989, when the yield curve was inverted. The right column is a five-year collar that could have been constructed last June, when the yield curve sloped upward.