Public & Private

Interest rates in the UK have fallen to levels not seen in 40 years. So, is now a good time to fix borrowing costs? If not, what are the alternatives?

By fixing borrowing costs you know what your annual interest costs will be for the duration of the fixed-rate period. But fixing the rate on borrowing incurs a cost known as an "opportunity cost", and you are giving up the opportunity to benefit from funding at the lower short-term variable rates. If the fixed rate for 10 years is 4.75% versus a floating rate of 4% (three-month LIBOR), the opportunity cost is 0.75%. The steeper the upward slope in the yield curve, the greater the opportunity cost.

The longer that short-term variable rates are below the original fixed rate, the higher those short-term rates will have to rise for the remaining period simply to break even with the fixed rate. The steeper the curve, the higher the break-even rate will be.

Caps, collars and floors
If you feel the opportunity cost is too great to lock into an outright fixed rate, but you still want protection against rates rising too high, one alternative is an interest rate cap. This is an interest rate insurance product that protects the buyer, should interest rates rise above a specific reference rate (the "strike rate"). The standard reference rate is three-month LIBOR. Like all insurance, you will pay a "premium".

The attraction of the cap is that, for a fixed cost, it allows you to borrow at the prevailing short-term variable rate while still being protected from a rise in interest rates above the strike rate agreed in the cap agreement.

One way to reduce the cost of buying a cap is to buy an interest rate collar. This combines the purchase of an interest rate cap with the sale of an interest rate floor. A collar that involves selling an interest rate floor at a premium that completely offsets the premium of purchasing an interest rate cap is called a zero-cost collar. The Prebon Marshall Yamane UK structured finance and risk management daily sterling rate sheet gives indications of zero-cost collars based on purchasing a 7% cap. The graph above illustrates the floor levels for a range of periods, assuming a cap strike rate of 7%.

The LIFFE short sterling futures curve shows what interest rates the markets are forecasting. Currently, short sterling futures are predicting that three-month LIBOR will be at 4% in December 2003 and will peak at less than 5% even by the end of 2006.

Your four alternatives
So you have four alternative strategies:

• borrow at the three-month LIBOR rate, 4.03%
  
• fix borrowing costs and borrow 10-year fixed rate funds at 5.09%
  
• hedge short-term borrowings with an interest rate cap – borrow at the three-month LIBOR rate of 4.03% and buy a 7% cap for £198,000 per £10m
  
• hedge short-term borrowing costs with a zero-cost collar – borrow at the three-month LIBOR rate of 4.03% with protection set at 7% (cap strike rate) and a minimum rate of 3.75% (floor strike rate).

The graph shows that different interest rate management strategies offer the lowest effective borrowing cost at different levels of interest rates. The funding strategy of variable borrowing with a 3.75%/7% zero-cost collar will produce the lower effective borrowing cost below 5.09% to 3.75% and fixed rate borrowing will be preferable if rates were to be significantly higher.

At the end of the day, your decision whether to fix borrowing costs or remain on a floating rate basis will depend on how much risk you are prepared to accept, the steepness of the yield curve and your view on interest rate rises.

See www.prebonsfrm.com for more information