How are borrowers adjusting their interest rate hedging strategies to take account of the impending General Election and the uncertainty surrounding the UK’s future relationship with the EU? Negative interest rates and refinancing risks remain hot topics. Some borrowers focus on certainty of funding costs while others are adding flexibility to their hedging plans.
The hedging decision is often driven by how long the debt is expected to be in place, which is a key factor in formulating any strategy. Alongside this are any hedging requirements within the terms of the debt facility, including covenant tolerance to higher cost of funds.
Last summer there were plenty of discussions around the prospect of negative interest rates in the UK as fears of a no-deal Brexit increased. Negative rates affect any borrower with a Libor floor in a debt facility that is hedged with an interest rate swap. If Libor were to turn negative, the borrower would be required to pay the negative floating rate in the swap but not receive the offsetting cash flow from the loan.
It is possible to add a 0% floor to an interest rate swap, but when swap rates are very low, as they were over the summer, this can be extremely expensive. Now that swap rates have moved higher, the cost of buying a 0% floor has fallen, but so has the perceived risk of negative rates. With this we have seen a drop in the number of borrowers actively looking incorporate floor into their interest rate swaps, despite the potential disruption that could be caused by the General Election.
Swaptions Favoured For Longer Dated Flexibility
Flexibility continues to be an important factor if there is a chance the debt facility may be refinanced before it has matured. Interest rate caps were previously a popular choice for many of our clients faced with this situation. More recently, though, swaptions have grown in popularity. This is particularly true if hedging for five years or beyond as the premium for a longer dated cap can be relatively expensive. Indeed, the breakeven rate, (the level the average Libor needs to fix below for a cap to be more economic than a swap), can be 20 – 30 bps below where Libor is currently fixing.
Interestingly, the current low interest rate environment has encouraged some borrowers to look to hedge longer than the underlying debt facility. With interest rates so low it is tempting to lock in to a longer dated interest rate swap in case the General Election brings an upwards shock to interest rates. But that strategy brings with it the risk of break costs if the debt is not extended. There is also no guarantee the lender will extend the debt even if it provides an interest rate swap for an extended maturity, so again swaptions are considered a suitable alternative.
The change in borrowers’ hedging behaviour since the announcement of the General Election has been subtle. What is clear is that borrowers do not want to introduce any unnecessary risks – but instead neutralise the risks they can control. Swaptions offer flexibility at a fraction of the cost of interest rate caps and have gained in popularity to mitigate both General Election and Brexit related risks.
By Rhona Macpherson, Associate Director at JCRA