Pros and Cons of ‘Blend & Extend’ for Interest Rate Swaps
*Originally Published on March 21, 2016. The idea of “blend and extend” continues to be a popular topic, and for good reasons. In light of the new rules, however, we’ve updated this popular classic for accuracy and comprehensiveness.
In recent months, numerous clients have asked us to weigh in on the possibility of “blend and extend” (sometimes called “amend and extend”) for their interest rate swaps.
In such a scenario, a company extends an existing pay-fixed rate swap over a longer period of time than its original term, at a lower interest rate if the swap is a liability (or a higher interest rate if the swap is an asset). The overall value of the swap remains the same, but its cash flows are spread over a greater period of time after the modification.
Naturally, as with all approaches to hedging and swaps, there are pros and cons to a blend-and-extend transaction.
A benefit from doing a blend-and extend on a swap which is a liability, is that short term cash outlays go down immediately. For instance, by spreading a two-year liability over five years, less cash goes out the door each period, though the total term of the liability increases. Additionally, a longer term means the protection from increasing rates provided by the swap remains in place for longer. A swap that is an asset can be restructured similarly to spread the asset value over a longer term via a blend-and-extend transaction, increasing cash outflows, but extending the period of fixed rate protection.
There are, however, hedge accounting repercussions when such an action is taken on a swap designated as an accounting hedge. Chief among these is the fact that the swap must be de-designated and re-designated; de/re-designation is required even under the updated and more liberal hedge accounting rules detailed in ASU 2017-12. At dedesignation the loss (or gain) in the derivative at dedesignation is frozen and must be amortized into earnings in a rational way. In short, your cash outlay may be reduced but your P&L expense recognition will not necessarily follow suit. Unlike cash those pre-blend and extend losses must come through income in the shorter original swap period. In addition, the financing element introduced (due the restructured swap having nonzero fair value) complicates the subsequent accounting, and a quantitative effectiveness test would need to be prepared to show that the financing element present in the restructured swap does not prevent the swap from being highly effective.
The blend and extend strategy will also offer less visibility into pricing and costs than simply entering into a brand new instrument, since the fair value of the derivative as of the modification date will be buried in the fixed rate on the new swap, a rate that will not be readily observable as an at-market rate, due the swap’s nonzero fair value as of the date of the modification.
So, is blend-and-extend right for your interest rate swap? That’s a question only you can answer. By looking closely at your goals, your liabilities and your short- and long-term liquidity needs, you’ll be able to make the call that makes the most sense for your company.
Of course, if you’d like a hand, we’d be happy to help; contact us anytime, or call 408-350-8580 to speak with one of our interest rate hedging experts.