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 on which both parties agree in advance.

Also called accreting swap, accumulation swap, construction loan swap, drawdown swap and step-up swap.

BREAKING DOWN 'Accreting Principal Swap'

Investors may use an accreting principal swap in instances where the borrower anticipates the need to draw down funds over a certain period of time but wants to fix the cost of the funds in advance. Cost projections may change over time so they match the funding via the 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 a Treasury bond, for the payments of variable rate investment, such as a mortgage, where the rate goes up and down as a function of a base rate. The mortgage could be based on LIBOR plus 2%, so as LIBOR 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

In this light, an accreting principal swap can help young companies that will need of 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, regulations, etc. will increase over time but do not want to wait to finance those future funding needs. They prefer a series of predictable future payments. And accreting principal swap can define these costs in predetermined tranches as each they move on to each stage of the project. The swap removes the interest rate variable.

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