CDFA Spotlight: Interest Rate Caps and Collars By Stan Provus

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This article explains interest rate caps and collars. These are instruments that protect floating rate issuers/borrowers from a rise in interest rates that would otherwise increase their borrowing costs. Future Learning Corner articles will include a review of other areas of development finance.

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This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel.

The protection achieved by interest rate caps and collars is applicable to borrowers who borrow long term with an interest rate that resets periodically, such as variable rate demand obligation bonds where the interest rate is reset weekly, as well as borrowers who borrow for a short term at a fixed rate and plan to roll the loan each time it matures.

By purchasing a cap, a borrower can limit or “cap” his maximum interest cost regardless of how high the rate on his loan or bond gets. When the loan or bond rate exceeds the cap limit (usually referred to as the “strike” level) the borrower pays the higher interest rate on the loan or bond. However, the seller of the cap compensates him for the exact amount of interest paid in excess of the strike price. The cost of the cap varies based on its term and the strike level chosen by the borrower. The cost is paid up-front to the seller and is quoted as a number of basis points of the loan or bond amount.

For example, an issuer issues floating rate bonds. The rate on the bonds is determined weekly based on the BMA (Bond Market Association) floating rate or swap index. The principal amount of the bonds is $10 million. On the issue date the issuer purchases a cap from a seller (investment banks, bond insurers, etc.) and pays $X to the seller. The seller agrees that if during any weekly rate period the interest rate on the bonds goes above say 4%, the seller will pay the issuer the excess of the floating rate over 4%, as applied to the agreed upon principal amount, called the “notional principal amount”--$10 million in this example. The 4% is the “strike” level.

A cap reduces an issuer’s or borrower’s risk that floating rates will increase substantially. By purchasing a cap, the issuer/borrower is certain that in no event would it be required to pay interest in excess of 4% in this example. Issuers/borrowers may use a cap rather than getting fixed rate debt so they can take advantage of floating rate debt which is generally lower than fixed rates and yet be assured their interest costs will be capped an at agreed upon level.

Similar to a cap, a collar allows a floating-rate issuer/borrower to limit his maximum interest cost regardless of the rate on his bond or loan. However, to reduce the cost of the protection, the collar includes an interest rate floor that limits his maximum interest cost regardless of how low the bond or loan rate becomes. Therefore, a collar has two strike levels, an upper (cap) strike and a lower (floor) strike. For example, an issuer and seller may agree on a 3% floor and 5% cap. This hedge effectively guarantees the issuer/borrower interest cost will always be in a “collar” between 3% and 5% in this example. If the interest rate for an interest period is 6%, the seller will pay to the issuer the difference between 5% and 6% or 1%. If the interest rate drops to 2%, the issuer must pay the seller the difference between the 3% floor and actual 2% rate or 1%.

By entering into the collar, the issuer/borrower is assured that its interest costs will not exceed an agreed upon cap strike level (5% in this example). On the other hand, the issuer/borrower will not receive a benefit if floating rates go below an agreed upon floor strike level (3% in this example). A collar, however, is less expensive to purchase than a cap.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.