What it means
When a company plans to borrow at a fixed rate, its final cost is made up of two parts: the yield on a government bond of similar length, and a spread on top that reflects the extra risk and cost. Both can move before the deal is completed.
A spread lock covers the second part. Two parties agree today on a spread, and when the future date arrives the one that is better off receives a payment from the other, calculated from how far the actual spread has moved from the locked level.
The benchmark yield, on the other hand, is usually handled separately, for example by a bond forward or a hedge on government securities. Together the two hedges allow the borrower to fix the all-in rate in advance.
Treasurers usually decide the size of each hedge by estimating how much debt they expect to issue. Corporate treasurers use spread locks because they plan funding months ahead.
A company expecting to issue bonds after a board meeting or a regulatory approval is exposed to market moves in the meantime, and a lock gives certainty on part of that cost. The tool is not free of risk.
If the spread narrows instead of widening, the borrower pays on the lock, but it then borrows at the narrower spread, so its net cost stays close to the locked level either way. Because the contract is a derivative, which is a financial contract whose value depends on something else, it needs documentation, credit limits with the bank and often hedge accounting treatment.
These practical steps are as important as the market view.
In practice
Real-world examples.
Example
A utility company plans to issue $200,000,000 of fixed-rate bonds in three months. It enters a spread lock so that a widening in the spread over the government benchmark will not raise its borrowing cost.
Example
A property group expects to sign a new fixed-rate interest rate swap after a sale completes. The treasurer fixes the swap spread now to remove one source of uncertainty before the sale closes.
Example
An infrastructure fund is bidding for a project that will need long-term fixed-rate financing. It uses a spread lock during the bidding period so that its offer price reflects a known cost of funds. If the bid fails, it can close the lock at the market value, which may be a small gain or loss.
Formula
Calculation
Settlement = (final spread - locked spread) x value of one basis point
A company locks a swap spread at 40 basis points (a basis point is 0.01%). By the settlement date the spread has widened to 55 basis points, and the value of a one basis point move on its planned swap is $4,000. Settlement = (55 - 40) x 4,000 = 15 x 4,000 = $60,000, paid to the company, which offsets the higher cost it now faces on its borrowing.Case study
Seen in the real world.
Redstone Water is an illustrative, fictional company that needed to raise $100,000,000 of ten-year fixed-rate debt but could not issue until its annual accounts were approved eight weeks later. The finance director worried that credit markets might become more nervous in the meantime.
She entered a spread lock at 45 basis points. During the eight weeks the spread widened to 60 basis points, and the lock paid Redstone a settlement of 15 times the value of a basis point, around $75,000 on a value of $5,000 per basis point.
That payment offset most of the extra interest the company had to accept when it issued. The illustrative lesson is that the lock worked as insurance, and the finance director made sure the board understood that it would have cost money had the spread narrowed instead. The board approved the approach for future issues, with the limit on each lock set by the treasury committee.
Watch out
Common mistakes.
- Assuming a spread lock fixes the whole interest rate, when it only covers the spread and not the benchmark yield.
- Forgetting that the lock can lose money if the spread narrows, which cancels out part of the benefit of the improvement.
- Entering the contract without checking the accounting and documentation requirements for derivatives.
Questions
People also ask.
What is the spread in a spread lock?
It is the difference between the swap rate, or the company's borrowing yield, and the yield on a government bond of the same length.
How is a spread lock different from a forward contract?
A forward contract locks an overall price or rate, whereas a spread lock fixes only the spread component and leaves the benchmark yield to be hedged separately.
Who offers spread locks?
Banks and dealers in interest rate derivatives offer them to companies and institutions, usually under standard derivative agreements with credit limits.
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