Traditionally, many borrowers have had a ‘set and forget’ strategy when it came to structuring their borrowings. Decisions tend to get made on the basis of the cheapest rate available at the time, irrespective of period, and with little consideration to the most appropriate tool – whether it’s a fixed rate term loan, floating rate term loan or an Interest Rate Swap.

The key takeout from here is:
• Cheapest may be more attractive in the short-term when there is a negative shaped yield curve (but the overall base rates could be high). So it may not end up being the cheapest over the duration of the period the loan when it returns to a normal interest rate curve, and overall base rates are lower.
• The above occurs when there is the movement in the interest rate curves and base rates as shown in the two graphs that follow:

Negative Interest Rate Curve (March 06)

Normal Interest Rate Curve (Nov 09)

 As a result of the change in the interest rate curves there has been some criticism directed towards certain borrowing products, in particular Interest Rate Swaps, and their duration, given the current lower interest rate environment.

Some of this criticism has been made with the benefit of hindsight and we think that it’s timely to re-cap what an Interest Rate Swap is and how it works.

So what is an Interest Rate Swap?

An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest Rate Swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR or Bank Bill Rate). A business will typically use Interest Rate Swaps to limit, or manage, its exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the Swap.

A Swap is not a lending facility and it doesn’t alter the terms of your underlying loan agreement. It is an interest rate management tool that can be used in conjunction with any variable rate lending facility (which is a facility under which you pay interest at a base interest rate plus margin).

It’s also important to remember that a Swap only affects the base rate applicable to your underlying loan agreement. The Risk Margin and any applicable fees are subject to change as per the conditions of the underlying loan agreement.

How does a Swap work?

A Swap helps protect against any movements in the bank bill rate in manner to a fixed rate loan, with the exception that it doesn’t lock in the banks risk margin. The borrower always pays monthly interest at the bank bill rate (BKBM) plus margin, and then is credited or debited the difference between the bank bill rate and the Swap rate to achieve funding at the agreed Swap rate (plus margin). This is shown in the examples below.

 The Swap interest rate is established at the beginning of the transaction, while the variable rate is the BKBM Rate (BKBM rate is the Bank Bill rate) determined on periodic Billing Dates (30 or 90 days).

What are the benefits of a Swap?

The flexibility to change. This is achieved by:
• ‘Averaging down’ the rate – by lengthening the term of the hedge if longer-term rates subsequently fall during the term of the Swap contract.

• Shortening the term of the Swap(s) – undertaken at the top of an interest rate cycle, to bring forward the value of the hedge to decrease the immediate short-term funding cost.

A Swap also allows you to manage your interest rate risk without affecting your underlying loan agreement. And there is no upfront premium.

What are some potential downsides of a Swap?

• Swaps enable you to ‘lock in’ a fixed base rate. This means you can’t participate in favourable interest rate movements.

• Swaps do not lock in your margin. It will still be determined by the terms and conditions of your underlying loan agreement.

• Early termination of a Swap agreement may incur a payout cost (break cost).

Interest rate management

When deciding on a strategy for managing your interest rate you need to walk through a set of ‘key considerations’ including:
• Your risk appetite.
• Sensitivity of your business to adverse interest rate movement.
• Long-term objective of your business.
• Cashflow requirements of your business.
• What stage of the life-cycle your business is in (start-up/development/growth/maturity/succession).

The key outcome of going through the above considerations is that you will establish an interest rate structure that you’re comfortable will help you reach the goals you’ve set for yourself and your business.

When there is so much uncertainty about the outlook for interest rates, it’s important to ensure your risk is being managed. Ask your Agribusiness Manager about how Westpac can help assess your interest rate risks, and provide solutions that meet your business needs.

If you’d like to discuss any of our specialist financial products designed for interest rate protection, our Agribusiness Managers will arrange a meeting with you and one of our Financial Market Interest Rate Specialists.

Subject to documentation and credit approval. The above products and services are provided by Westpac Banking Corporation ABN 33007 457 141, incorporated in Australia operating in New Zealand as Westpac Institutional Bank. For more information or a copy of the product disclosure statement for any product for which a product disclosure statement is required, please contact a Westpac International Business Manager.