Question

Betsco, Inc. has previously issued a bond that currently has 7 years left until maturity. The coupon rate of the bond is tied to LIBOR (specifically, its rate is LIBOR + 5%). The Director expects interest rate movements to negatively affect the interest expense generated by this debt obligation. Therefore, she wishes to effectively change her liability from floating to fixed. The most recently issued Treasury Note is yielding 6%. She contacts several banks that quote her the following:

Bank A: “We will refinance your current debt at an “all-in” annual cost of 10.55%. This will include all the expenses of retiring the current debt and issuing new debt at a fixed coupon.”

Bank B: “We will offer you a LIBOR+2% based, 50-75 interest rate swap.”

Bank C: “We will offer you a PRIME+3% based, 45-48 interest rate swap.

In addition, we have a basis swap available: LIBOR – 1% for PRIME + 2%.” Which bank offers the Director the best net borrowing position. Think that the Director wants to effectively change her liability into a fixed obligation?

Answer 1

LIBOR (London Interbank Offered Rate) is globally referred as benchmark to determine interest rates cross the world for corporate loans, government bonds etc. It is determined by benchmark base rate plus fixed spread. It recommends big banks in London on what average rate they can borrow short term loans from other banks.

As per question, Betsco, Inc. issued a bond which has floating coupon rate as LIBOR plus margin 500 basis points or 5% (1% = 100 basis points). However, the floating rate of debt instrument hedges the fluctuation in market interest rates, but sometimes par fluctuation causes negative impact on the interest expenses. Whereas, in fixed interest rate increase in market interest rate benefits the borrower and decrease in market interest rate benefits the lender. Therefore, the director, in order to protect company's interest, effectively desired to change her liability into a fixed obligation, as positive movement in LIBOR may increase interest payment towards debt obligation.

When an investor desires to enters into swap, the difference between expected floating interest and future fixed interest rate should be zero, so as to be in no profit/loss zone.