The investment world has many well-known and lesser-known terms. Think of stocks, bonds, options, futures, or swaps. In a special series, we explain the characteristics and history of the various investment categories. In this episode, Alex Tiebout, Expert Portfolio Manager at APG, discusses a lesser-known instrument: the interest rate swap, which is a derivative instrument.
Published on:
17 October 2023
The interest rate swap in brief
What is it?
An interest rate swap is a financial product in which two parties, usually a bank and a company, exchange fixed and variable interest rates. They use this to hedge interest rate risks, especially when it comes to variable interest rates.
When did it originate?
Interest rate swaps have been in use since 2001.
What else is involved?
The value of an interest rate swap is highly dependent on prevailing interest rates.
What is it?
An interest rate swap is a derivative. This means that it’s a derivative product, based on the price of an underlying value. In this case, that value can be likened to a stock and is a reference to an interest rate level.
With an interest rate swap, the borrower – usually a company – exchanges a variable interest rate (short term) for a fixed interest rate (long term). Depending on whether you receive or pay fixed interest, it’s beneficial when the interest rate decreases or increases, respectively. That sounds simple, but it’s not, says Alex Tiebout, who has worked at APG since 2010, and before that as a trader on the ABN Amro trading floor. “Because, just like with other derivatives, it’s not about a tangible asset such as stock, real estate, or a commodity. An interest rate swap is an exchange of interest rate. The bank and the company exchange variable interest and fixed interest rates. The company receives the variable interest it pays on the loan from the bank. In return, the company pays a fixed interest rate to the bank. This is done via the swap. The loan itself doesn’t change, nor do the conditions. The result is that the company is protected against interest rate increases. After all, the variable interest rate can change suddenly, but the fixed interest rate can’t. This gives the bank more certainty.”
What else is involved?
An interest rate swap doesn’t always work out well, says Tiebout. “There are quite a few risks, especially for the entrepreneur, if the variable interest rate keeps declining. The value of the swap then decreases, and if it becomes negative, a debt is created. The entrepreneur must usually deposit this debt as collateral with the bank. The entrepreneur must have that amount of cash on hand. If that’s not the case, banks can call in the debts, with all the consequences that entails. After the crisis in 2008, this caused several problems for many companies, organizations, and even governments because interest rates continued to decline and even became negative. Consider the debacle at housing association Vestia, where two billion euros evaporated due to swaps. Due to the declining interest rates, a lot of cash had to be paid. That money wasn't there. This had fatal consequences, because a loss or profit on a swap or a future is settled in cash.”
When did it originate?
After the turn of the millennium, banks faced declining interest rates that put pressure on their margins. Combining loans to companies with interest rate swaps turned out to be part of the solution. Interest rate swaps have now become a permanent fixture in the financial world.
Is this something that APG should avoid?
Not at all, answers the portfolio manager. “Swaps are an excellent instrument for hedging risks and cushioning major fluctuations in the markets. For a pension fund, for example, you cushion the effects of a rapid interest rate decline with an interest rate swap. After all, pension obligations increase with declining interest rates. That is offset by the increase in value of interest rate swaps due to the same interest rate decrease. At APG, this is also our guiding principle when we work with derivatives: hedging risks for pension funds and their participants. It’s an essential part of our portfolio policy to limit market fluctuations and keep the coverage ratio as stable as possible.”