A company has a $500M Term Loan B maturing in 7 years with a SOFR + 350 bps margin and a 50 bps floor. The forward SOFR curve implies rates will average 2.8% over the life of the loan. A bank offers a 5-year interest rate swap at a fixed rate of 3.20% against SOFR. Describe the net borrowing cost if the company enters the swap for the full notional of $500M and if it only hedges 50%.
AdvancedModel answer
Unhedged rate = SOFR + 3.50%, with a SOFR floor of 0.50%. Forward SOFR 2.8% > 0.50%, so floor irrelevant. Unhedged cost = 2.8% + 3.50% = 6.30%. If fully hedged with pay-fixed 3.20% receive-floating SOFR on $500M, the net rate becomes 3.20% + 3.50% (credit spread) = 6.70% (the floating SOFR cancels). So full hedging increases the rate by 40 bps relative to unhedged because the fixed swap rate is above the forward SOFR. If 50% hedged, blended rate = 0.56.30% + 0.56.70% = 6.50%. The company gives up the potential benefit if floating rates fall but locks in a known cost. Follow-up pressure: (1) If the company instead bought a cap at 4.00% on SOFR for a premium of 25 bps annually, what would the effective cost be in the two scenarios? (2) How would the swap be accounted for under hedge accounting, and why might a sponsor prefer not to apply hedge accounting? (3) If the company’s credit rating improves and its loan margin is repriced to S+300, what happens to the hedge’s effectiveness?
This is an advanced Superday-level question with a full model answer, part of IB Atlas's practice bank.
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