Negative interest rates and pre-hedging upcoming interest rate exposure were factors when devising hedging strategies last year. At the start of 2020 both scenarios remain relevant although the need has shifted.
The UK election result removed some of the uncertainty that blighted financial markets in the final quarter of last year. Nevertheless, the future direction of interest rates splits opinion. Although creating a hedging strategy is not about “beating the market”, a view on interest rate moves can shape a hedging strategy.
The expectation that GBP interest rates will turn negative has fallen, even amongst those who think they are likely to fall further. During July and August last year when fears of a no-deal Brexit increased, concern about negative interest rates was rife. For borrowers with Libor floors within their floating rate loan agreements, the threat of negative interest rates created a dilemma.
Hedging negative rates
Interest rate swaps are commonly used to hedge the Libor risk in a floating rate loan. But if Libor turns negative, the borrower would be required to pay the negative Libor rate on the swap and would not receive it back under the loan facility, increasing the borrowers’ cost of funds.
Negative interest rates remain a possibility, however we have seen a fall in the number of enquiries to hedge the Libor floor in a debt facility. Methods to hedge this risk include adding a floor to the floating leg of an interest rate swap or by buying an interest rate cap.
When adding a floor to an interest rate swap, cost is a factor, despite floors being cheaper now than they were back in July and August last year. Back then the five-year swap rate was in the mid 50bps and the cost to include a floor in the interest rate swap was over 20bps. It would now add just under 10bps to the fixed rate of a five-year interest rate swap.
Interest rate caps
Interest rate caps are an obvious alternative to a floored interest rate swap to navigate the issue of negative rates. However, now that interest rates are higher, cap premiums have also increased, which has deterred some borrowers from using this strategy. To compare the two, it can be useful to consider the breakeven rate for the interest rate cap. The average Libor fixings need to be below the breakeven rate for the interest rate cap to be more economical than an interest rate swap for the life of the product. For a five-year cap with a 1.25% strike, Libor would need to average below 0.65% to be more economical than a floored interest rate swap for the same period.
There are also borrowers who are concerned that interest rates will push higher. This is partly fuelled by an expected rise in government borrowing to deliver the investment promised during the election campaign. It’s expected this will have a greater impact on longer dated interest rate swaps rather than the front end of the interest rate curve.
Those expecting interest rates to remain “low or lower for longer” appear to be in the majority, but that hasn’t resulted in a meaningful shift towards hedging the risk of negative interest rates. At the same time, now that swap rates are higher, the majority of swaptions are bought to hedge the extension element of an agreed debt facility rather than unknown future debt requirements. If swap rates do fall it may encourage the opportunistic use of swaptions that we witnessed last year.
By Rhona Macpherson, Director at JCRA