What does a change of chancellor mean for borrowers?

The general election was meant to remove much of the political uncertainty from markets. However, Sajid Javid’s surprise resignation as chancellor was a stark reminder that nothing can be taken for granted. But what do changes at the Treasury mean for borrowers?

The reshuffle was meant to be a low-key affair, with only junior ministers to be changed. However, Number 10’s ultimatum to the chancellor to sack his special advisors and have them replaced by a wider Number 10 contingent was too much for Javid to accept. He said he’d rather quit than accept conditions that “no self-respecting minister could”. Whether he seeks revenge from the backbenches remains to be seen.

Javid’s replacement, Rishi Sunak (also an ex-banker), has been greeted with an element of relief by the City. Markets suspect that Sunak is more willing to support an increase in government spending and investment compared to Javid. In all likelihood, this will be funded by additional gilt issuance – putting an upward pressure on yields.

There was an immediate impact on swap rates which have pushed higher since Javid’s resignation. This was particularly noticeable for medium to longer maturities, with swap rates in the five to ten year segment up around 8bps. So, what should borrowers be thinking about?

Swap rates were already edging higher before Javid’s resignation, so to some extent the move was “pushing an open door”. In January there was talk of a base rate cut, but that expectation is being slowly eroded and replaced with the view that the next base rate move will be an increase, albeit in a year’s time.

For borrowers with new debt facilities referencing Libor, there is a preference to fix the cost of borrowing with swaps rather than buying caps to hedge interest rate (Libor) risk. But what about borrowers with upcoming funding plans who have potential rather than realised interest rate risk? Hedging is not about “beating the market” but protecting the borrower against unfavourable increases in funding cost. However, what if you think swap rates are on the rise, and want to lock in a favourable fixed rate before the debt facility has been finalised? Pre-hedging with a swap comes with potential break costs if the facility does not go ahead as planned and the swap needs to be unwound.

Last summer, when swap rates fell, several borrowers who wanted to lock in lower swap rates bought swaptions to hedge the interest rate risk associated with upcoming debt facilities. A swaption provides the borrower with the right, but not the obligation, to enter into a swap on an agreed exercise date at a pre-specified fixed rate. This gives the borrower a known maximum future fixed swap rate while maintaining the flexibility to benefit if swap rates are lower at the exercise date. It also avoids the threat of swap break costs. So far, 2020 has not seen the same impetus from borrowers to use interest rate swaptions to hedge future borrowing.

So, while swap rates could be on the rise as a result of the change in chancellor, this has not yet prompted borrowers to reassess their hedging strategies. It seems that swaptions, and pre-hedging more broadly, are strategies employed to hedge uncertainty rather than to lock in prevailing swap rates in anticipation of higher swap rates to come. Back to the mantra that hedging is not about “beating the market”.

By Rhona MacPherson, Director at Chatham Financial