Amidst pressures to enhance operational productivity and quality, American manufacturers also face challenges in selecting the most cost-effective means for financing immediate and long-term expenditures.
Current financial market conditions present an opportunity to use interest rate swaps to reduce the amount of interest companies pay on short-term lines of credit used to finance inventory purchases or other present needs.
An interest rate swap is essentially a contractual agreement between two parties to exchange interest rate payments for a defined period of time. The contractual terms are based on a notional principal amount that serves as a reference point, but is never exchanged.
Such swaps occur when two companies each have interest rate payment terms that are more beneficial to the other entity. One company, for example, might wish to swap its floating rate interest payments for another corporation’s fixed rate interest payments. Corporate credit ratings and an individual entity’s short-term and long-term financial priorities affect such decisions. Disparities and fluctuations in international currency valuations also influence interest rate swap objectives.
The first interest rate swaps took place in the early 1980s. Today, the annual notional value of interest rate swaps occurring in the international market totals hundreds of trillions of dollars. Interest rate swaps may be initiated to hedge interest rate risk, to enhance liquidity, to speculate on future movements in interest rates and to reduce the cost of funding.
Interest rate swaps can be rather large. They can be rather complicated, too. When used for speculative purposes, they can also be rather risky. Current circumstances, though, make them an attractive and relatively straightforward option for lowering interest payments due on a portion of a company’s short-term line of credit.
Interest rates for short-term lines of credit are based upon the short-term interest rates established by the Federal Reserve Board, whereas long-term interest rates are set by various financial market forces. Short-term interest rates are currently higher than long-term borrowing rates, creating an inverted yield curve.
With that yield curve, manufacturers can realize significant interest rate savings by swapping the interest rates they’re paying on portions of a short-term line of credit for another entity’s long-term interest rates.
To understand the savings realized, consider the following scenario:
Assume a company has a $20 million short-term line of credit, and that it currently pays 6 percent in short-term interest rates on the funds it borrows to purchase inventory and meet other immediate operational needs. The company has the opportunity to swap that short-term rate on half of its line of credit—$10 million—for a long-term interest rate of 4 percent. The different in two percentage points on interest for $10 million is $200,000—a substantial savings that immediately enhances a company’s cash flow and overall financial health.
Such swaps incur a fee that is typically based on the differences in interest rates being traded. A variety of over-the-counter (OTC) brokers can arrange such interest rate swaps. For a company in good financial standing with a solid credit history, however, the best place to initiate such a swap is with the organization’s existing lender. Such institutions are familiar with company operations, and are likely in a position to offer better interest rate swap terms.
Interest rates and financial market conditions change over time, necessitating that companies pay continual attention to such fluctuations to determine what particular scenario works best for them. For current market circumstances, swapping short-term interest rates for lower long-term rates on a short-term line of credit can provide significant, immediate savings.
Phil Simoens, [email protected], is a Tax Senior Manager with Weaver and Tidwell L.L.P.