What Is an Accreting Principal Swap?
An accreting principal swap is a derivative contract in which two counterparties agree to exchange cash flows—usually a fixed rate for a variable rate, as with most other types of interest rate or cross-currency swap contracts. However, in this case, the notional principal amount increases over time on a schedule to which both parties agree in advance. Swaps are traded over-the-counter (OTC) so the terms can be tailored to the parties involved.
The product may also be called an accreting swap, accumulation swap, construction loan swap, drawdown swap, and step-up swap.
- An accreting principal swap is the same as a vanilla swap, except that notional amount of the swap grows over time.
- Accreting swaps are useful if cash flows grow over time. This way the swap matches the cash flow.
- The terms of an accreting swap are agreed to in advance by the two parties, including the schedule of how much and when the notional amount will increase.
Understanding an Accreting Principal Swap
Mainly businesses and financial institutions, along with some large investors, may use an accreting principal swap.
In a regular or plain vanilla swap, one party reduces exposure to risk while the other accepts that risk for the potential of a higher return. Typically, the notional principal amount of the swap contract stays constant. However, in an accreting principal swap, the notional principal grows over time until the swap contract matures.
Parties in a vanilla swap might exchange the payments of a fixed-rate investment, such as a Treasury bond, for the payments of variable rate investment, such as a mortgage, where the rate goes up and down. The mortgage could be based on the prime rate plus 2%, so as the prime rate varies, so will the mortgage payment.
The reason for the exchange is for one party to essentially fix the payments of his or her variable rate investment. The other party might have a view that interest rates will move in a favorable direction and is willing to take the risk, via the swap, that they will.
Instead of bond or mortgage investments, the cash flows might be from a business. Or the cash flows might be needed to fund a business. In either case, the need for fixed cash flow or a hedge against rising costs are factors.
Using an Accreting Principal Swap
An accreting principal swap can help young companies that will need increasing amounts of capital. It is often used in construction, where long-term projects have increasing costs over time.
For example, a construction company wants to create a predictable structure for the interest costs of projects. They know costs for labor, materials, and regulations will increase over time and want to make arrangements for that now. They prefer a series of predictable, increasing, future payments. An accreting principal swap can define these costs in predetermined tranches as they move on to each stage of the project.
It could also be used when two parties want to add further to the investments or debts they are swapping. For example, if an investor knows they are increasing their contribution to an asset by 10% each year, they could enter into an accreting principal swap so that the swap amount matches the investment amount.
Example of an Accreting Principal Swap
Assume there are two investors that are contributing to interest-bearing assets.
- John is receiving the fed funds rate plus 1% on his investment of $1 million.
- Judy is receiving a fixed rate of 3% on her $1 million investment.
- The fed funds rate is currently 2%, so John and Judy are both receiving the same amount of interest right now.
John is worried interest rates may go down, which would drop his return below 3%. Judy, on the other hand, is willing to take the risk that interest rates will stay the same or go up. Therefore, she is willing to enter into a swap with John.
John will pay Judy the fed funds rate plus 1% (which is what he receives from his investment) and Judy will pay John 3% (which is what she receives from her investment).
That would be a normal vanilla swap. But now assume that John and Judy are both adding $50,000 to their investment each year. They want the swap to apply to those additional contributions as well.
This is where the accreting aspect comes in. The notional amount for this year will be $1 million, but next year it will be $1,050,000. The following year $1.1 million, then 1.15 million the following year.
The swap will expire on a date agreed to in advance, such as when the investments mature, say in five years. Over those five years, the notional amount will grow by $50,000 each year.
The notional amount is not exchanged. If the interest rates are the same, there is no exchange of cash. If the interest rates end up different (rates move up or down from the current level) then the party that owes pays the other the difference in the interest rate on the notional amount.