Interest rate swaps are a derivative investment that have been around for almost three decades. Companies use this type of derivative as a hedge – in other words, to protect themselves from volatile interest rate fluctuations. The underlying securities are often corporate bonds, and companies trade their interest rate payment streams with each other to make payments on the other party's debt at interest rates that work better for them financially.
Interest Rate Swaps Explained
An interest rate swap is a financial agreement between two parties, in which a stream of interest payments is traded for another interest payment stream, based on a specified underlying instrument such as bonds. These types of swaps typically involve exchanging a fixed interest rate for a variable, or floating rate such as LIBOR, the London Interbank Offering Rate, with the goal of reducing or increasing a party's exposure to interest rate fluctuations. Another goal is to obtain a lower interest rate than available without engaging in the swap.
The Purpose of a Swap
Interest rate swaps are securitized as investment instruments, often used in hedging transactions. The swaps are traded in the over-the-counter market, and the contracts may involve more than two parties, according to their needs and specifications. Interest rate swaps are often used by companies that can borrow money with one type of interest rate but prefer a different type of interest rate. Corporations that engage in these swaps use them to effectively manage their debt payments.
These types of derivative instruments were originally conceived to help companies "smooth" the information on their balance sheets. Rather than having fluctuating interest liabilities on the balance sheet each month, for example, a swap can regulate cash flows so that the balance sheet, a snapshot in time, becomes more consistent from one period to the next.
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Corporate Taxation of Swaps
Although not much has been established by the IRS regarding corporate taxation for interest rate swaps, it has issued a field service memo concluding that interest rate swap periodic payments qualify as a business expense deduction, under Internal Revenue Code section 162. Interest income from swaps is treated as investment income to the business, allowing it to record the income as a capital gain or loss, and use the corresponding capital gains tax rates.
Tax Treatment for an Individual Investor
Speculative investors can choose to buy interest rate swaps, although, like corporations, the IRS has yet to address much in the way of specific taxation guidelines for these investors, even though swaps have been traded in the OTC market for many years. Currently, any interest income or loss resulting from an investor's interest rate swap falls into the investment income category and is taxed as a regular gain or loss on investment.