Interest rate risk is the risk that changes in interest rates will adversely affect a borrower's debt service costs or a lender's income. In a floating-rate credit market, where most leveraged loans, ABL facilities, and private credit instruments are priced as a spread over SOFR, both borrowers and lenders face meaningful interest rate exposure that requires active management or structural mitigation.
For borrowers, rising interest rates increase debt service costs on floating-rate loans. A company with $100M of debt at SOFR + 400 bps sees its annual interest expense rise by $1M for every 100 basis point increase in SOFR. For highly leveraged borrowers — where interest expense already consumes a large share of EBITDA — rapid rate increases can impair interest coverage ratios and trigger covenant violations. Managing this risk is a treasury function with significant credit implications.
Interest rate caps are the most common tool for floating-rate borrowers to limit upside rate exposure. A cap is an option contract that pays the holder when the reference rate (SOFR) exceeds a strike price. A company buying a 3% SOFR cap is essentially insuring against SOFR rising above 3% — the cap seller pays the difference between SOFR and 3% whenever SOFR exceeds the strike. Many lenders in leveraged and private credit require borrowers to purchase rate caps as a condition of the loan, protecting the lender's interest coverage analysis from rate shock scenarios.
Interest rate swaps allow parties to exchange floating-rate cash flows for fixed-rate cash flows (or vice versa). A "pay-fixed" interest rate swap converts a floating-rate obligation to a fixed rate — the borrower pays a fixed rate to the swap counterparty and receives the floating rate, net-settling the difference. The net effect is equivalent to having borrowed at a fixed rate. Swaps are more flexible than caps (they can fully hedge rate exposure) but also expose the user to the risk that rates fall below the fixed rate.
For lenders — particularly banks funding floating-rate loans with fixed-rate deposits or fixed-rate bonds — rising rates on assets may be beneficial, while fixed-rate funded institutions face net interest margin compression. The interaction of asset repricing rates and funding repricing rates is the core of bank interest rate risk management, monitored through income simulation and economic value of equity models by bank treasury and regulatory risk teams.