Interest rate derivatives

Everyone I talk to about IP says you should go for a fixed rate to minimise your risk.

But has anyone looked into using a fixed/floating interest rate swap to hedge the risk of interest rate movements. If you had several properties it might make sense to use swaps and it gives you the added benefit of being able to find the best variable mortgage and the best swap price seperately -- from different banks.

I am interested to know if anyone uses this kind of strategy and whether it is better (cheaper?) for property finance?

Andrew.
 
There being no takers on this I decided to do a bit of digging around myself -- show some initiative man!!

OK - here's the lo-down on interest rates.

If you want to fix interest rates, what is the best method? [The question: Do you want to fix rates? I will answer in another post]

>> Short answer: Get a fixed mortgage (3yr terms seem very well priced)......Crikey, what did you think -- It's not rocket science (apologies to John for trademark infringement)

>> Long (winded) answer:

Well it turns out that the mortgage market is very efficient - at least as efficient as big corporate banking.

First some figures: (100 basis points or bp = 1.0%)
Official Cash Rate.... 475 bp
90day Bank Bill Rate.... 480 - 515 bp (varies according to market supply/demand for funds)
Std var mortgage.... 600 bp
5 yr fixed mortgage.... 698 bp
5 yr SWAP.... 580 bp

Now the Std Var Mortgage rate is basically (but not exactly) pegged to the Official Cash Rate (set by the RBA) so we say a mortgage is at a 125 bp premium to the OCR; that is: StdVarMort = OCR + 125 bp.

An interest rate SWAP (in simple terms) is a transaction whereby party A pays a fixed rate to party B, and party B pays a floating rate to party A; on a NOTIONAL principal amount (only the interest difference changes hands). The floating rate is basically set as the 90 day Bank Bill Rate (at the time of interest payment). The fixed rate is priced based on interest rate expectations over the term of the swap. Sooo..... The 5 yr swap rate of 580 bp is priced at a 75 bp premium over the Bank Bill Rate (BBR). That is: party A pays 5.8% to B, and party B pays the BBR to A (currently 5.05%) -- on a notional principle of say $1M.

The fact that Mortgages are pegged to the OCR and Swaps are pegged to the 90 day BBR makes for an imperfect hedge. The 90 day BBR (the banks cost of funds) moves independently of the OCR by between 5 - 35 bp. Therefore you could say BBR = OCR + e; where "e" is some error term between 5 - 35 bp.

Why would you enter into a swap... well it turns your variable payments into fixed. Here's how... say you have a variable mortgage of $1M and you enter into a swap transaction to hedge interest rate movements for 5 years.
(Mortgage) You pay: OCR + 125 bp
(Swap) You pay: 580 bp
(Swap) You receive: BBR (or OCR + e)

All together you get: OCR + 125 bp + 580 bp - OCR - e = 705 bp -e. So the all up cost of this strategy varies between 670 - 700 bp. Compare this with the current 5 yr mortgage of 698 bp and why would you bother!!

Swaps also have a minimum notional principle requirement of $500,000 and require 3 %pa security over something. Consider these and its a one horse race...

So after all this pain I have discovered that the fixed mortgage market is probably your best bet.... now someone could have just told me!!
 
G'day Andrew C,

So after all this pain I have discovered that the fixed mortgage market is probably your best bet.... now someone could have just told me!!

Since I had NO IDEA what a SWAP was, I figured I'd just shut up and let you tell me :)

And you've done so - admirably,

Regards,
 
Do you want to fix rates?

Well.... every one says its a good idea to know what your repayments are blah blah, but the fact remains that the bank invariably wins out of every fixed mortgage transaction (I can't remember the study that looked at this but let's just say its true). This means fixed payers paid more interest than they would have if they were on a variable rate over the same period. This should not surprise anyone because the banks have an incredible information advantage -- they know more about future rates than you or I.

(And don't go thinking that the banks lose on any transactions because they generally, if their treasury risk management is good, sit in a neutral position. They pool all their transactions together, some cancel each other, then they hedge the rest and make a 10 - 30 bp margin (who know's) on each transaction -- that is unless they want to make a "play")

But what if I have a variable rate and rates go spiralling upwards? Well here's the deal:

A. Rates are below their long term average. The RBA has already come out and said that the OCR target is 550 bp (5.5%). That will take var mortgage rates to about 6.75%.

B. Despite this rates are down. With world happenings at the moment I suspect rates will be below their long term targets for a while... what with Sept 11 and now Bali -- and who knows what next -- a war with IRAQ seems inevitable. That is perhaps why 3 yr and 5 yr fixed mortgages are at such good rates. The interest price in the futures market 3 years from now is low.

C. If you have a few loans you can have a mixture of fixed and variable that will provide you some protection against adverse movements. And you can up the rent if possible to cover the residual.....

D. You can get protection in other (more efficient perhaps) ways. Consider an interest rate cap. I believe you can get variable loans with this feature but you can also "buy" them separately from banks -- though they are pegged to the BBR so are not a perfect cap for mortgages (but close enough). They require an upfront premium to be paid and no security -- consider it like insurance for 5 years. I do not know what minimum notional principle amounts are but the premium will get cheaper the further your cap is from the current BBR. A cap at 7% will be cheaper than one at 6% (but don't forget the mismatch between mortgages and BBR). If you have a cap at 7% and the BBR goes above this, then the bank will pay you the difference (every quarter I believe) and you can use this payment to reduce your variable mortgage obligations.

I haven't looked around at caps but if I do... you'll all be the first to know.

Am I still talking to myself!??? Hope this was useful to someone!
 
Banks have the power in this case

Originally posted by AndrewC
Do you want to fix rates?

Well.... every one says its a good idea to know what your repayments are blah blah, but the fact remains that the bank invariably wins out of every fixed mortgage transaction (I can't remember the study that looked at this but let's just say its true). This means fixed payers paid more interest than they would have if they were on a variable rate over the same period. This should not surprise anyone because the banks have an incredible information advantage -- they know more about future rates than you or I.

The research was publicised earlier 2001. It showed (from memory) fixed beat variable cost on three month over the last five years. i.e. Every month a notional mortgage was priced at prevailing fixed or variable rates -- even with the rate tightening fixed was cheaper in only 3/60 months.

I think the there are two main reasons for this. You've touched on the main one which is banks set the fixed price (technically not but effectively so). Secondly the interest cycle has been down to neutral over the previous five years. I'd like to see rolling 7 year research (to match the average term of a first mortgage).


Originally posted by AndrewC
Am I still talking to myself!??? Hope this was useful to someone!

Most definately not. But I think the technical talk intimidated some of us ;).

I was surprised that a swap was available on as little as $1M so thanks for that reseach.

One point from my perspective. Residential investors have "lumpy" portfolios. Very few investors have 10+ IP's. And almost no residential IP's are worth more than $1M. Trading within the portfolio becomes expensive if each property does not stand alone. Even without cross-collateralisation the documentation can be risky.
 
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Thank You Gentlmen.
I have a fixed at 3yrs and another at5yrs and have been wondering what to do with my next loan ( probably in 60 or so days ). Its not just that there is the information and advice but also people are prepared to sitdown and share it. No Paul you were not talking to youself!!!!!!!!!!!!!!!!
Thanks again Elwyn.D
 
Hi Andrew, Paul. Les and the rest,

I agree that variable is cheaper than fixed.

The question most asked of me is what to do when the interest rate spikes up during the 3/60 months and in most cases over a more rare but longer time period.

The idea of capping the rate is good but expensive. Also too, the individuals cash flow risk profile needs to be assessed.

The question might well be: How long can one tolerate the interest rate spike, from a cash flow point of view.

Lets say interest rates increase to 15% and stay there fore 5 months before coming back to an acceptable cash flow level:

Can you cashflow the 5 months?? (Or longer perhaps, as you can't know this in advance.)

What is reasonable cover? Say being able to cash flow the increase for 2 years??

One of the side benefits of the cashbond, is that the extra income generated, whilst not meant to be wasted in any way, can be used to fund these interest variations.

Just a thought you might find of interest, because although I only recommend this structure where necessary to enhance serviceability, some of the cash flow consequences are extremely useful.

Regards,

Steve
 
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