Managing Interest Rate Exposure in a Rising Rate Environment July 2018
As the era of ultra-low interest rates comes to an end, we review the US Federal Reserve and European Central Bank policy and interest rates from before the financial crisis through the economic recovery of recent years. We will then look ahead at ways to manage interest rate risk as the adjustment to more normalised monetary policy continues. Why should you read this? If your business is paying interest at a variable rate, what level of volatility in interest rates can your business tolerate? What Interest rate risk management solutions are available to your business? What factors should you consider when selecting the right solution? Authors: Ciaran Cash Corporate Treasury Risk Solutions Edward Preston Head of Corporate Interest Rate Risk Management
Managing Interest Rate Exposure in a Rising Rate Environment Pre-Financial Crisis: In 2007, confronted with a sub-prime mortgage crisis and contracting US economy, the US Federal Reserve started an unprecedented cycle of monetary easing. In 15 months, official US interest rates fell by 5% to 0.25%. In July 2008, despite growing signs of economic slowdown in Europe, the European Central Bank (ECB) raised interest rates to 4.25%, reinforcing their commitment to price stability. Rising food and energy prices in Europe threatened the ECB s mandate to maintain inflation below, but close to 2%, over the medium term. It was the eve of the greatest financial crisis in history. Within a few months the global economy collapsed, inflation disappeared and the July rate hike Source: Bank of Ireland Analysis, July 2018 was reversed by a 0.50% rate cut three months later. Economic Recovery: The US Federal Reserve left rates anchored at 0.25% for 7 years and added additional monetary stimulus through quantitative easing (QE). QE expanded the Federal Reserve s balance sheet through asset purchases of government and mortgage-backed securities over 4.5 times to $4.5 trillion by 2015. However, even as US growth and unemployment recovered, inflation remained stubbornly below target. ECB policy response lagged the US throughout the cycle. The US were first to cut rates, bringing rates to their lowest point and starting quantitative easing over 7 years before the ECB. The slower response from the ECB was despite the Eurozone battling a sovereign debt crisis and fiscal austerity creating a drag on the economy. Unsurprisingly the US, having acted first, led the global economy out of recession. The Eurozone economy regained momentum and grew strongly through 2017, however inflation remains below target. Long-term Euro interest rates reached their lowest point in mid-2016. Source: Bank of Ireland Analysis, July 2018 Since then Euribor forward prices have continued higher anticipating the recovery and the timing of the first official ECB rate hike. 3
Managing Interest Rate Exposure in a Rising Rate Environment Monetary Policy Normalisation: In December 2013, the US Federal Reserve announced a tapering of asset purchases and ended quantitative easing altogether in October 2014. This prepared the way for the first official rate increase in December 2014, marking the end of an era of ultra-low interest rates. The Federal Reserve funds rate now stands at 2%, with the forward market currently projecting US rates to continue higher and plateau just above 3%. The ECB recently indicated quantitative easing would end in 2018, with the first official ECB rate increase unlikely before the end of 2019. A softening of Eurozone economic activity in Q1 2018, political uncertainty in Italy and global trade tensions pushed out this timeline and flattened the Euro yield curve. That said, the recent German inflation of 2.2% yearon-year surprised market expectations and has reignited the conversation on ECB policy normalisation. The Euribor forward curve at present, suggests a first ECB rate hike toward the end of 2019, with rates rising thereafter at a moderate pace to c.1% in five years. Source: Market Data Bloomberg, June 2018 Source: Bank of Ireland Analysis, July 2018 Source: Market Data Bloomberg, June 2018 4
Managing Interest Rate Exposure in a Rising Rate Environment In Summary: Could ECB President Mario Draghi conclude a full term of office in October 2019 without ever raising interest rates? Following the recent German inflation print above the ECB s own 2% benchmark of price stability, is the current outlook for Euro interest rates too benign? The strength of economic growth and inflation in the Euro- Area as a whole will determine whether Euro rates over / undershoot current expectations. The question for those paying interest at a variable rate, what level of volatility in interest rates can your business tolerate? For those with term debt priced off a variable benchmark, read on for 4 strategies to manage exposure to interest rate risk in a rising rate environment 5
Solutions 1. Staying on a Variable Rate Understanding Euribor (European Inter-Bank Offered Rate) Euro corporate debt is generally priced off a 3 month Euribor benchmark. A Euribor rate for 8 different maturities from 1 week out to 12 months is published every day, representing the rate at which large money market transactions are agreed between prime Banks within the Eurozone. In a rising rate environment, the first risk to recognise is that 3 month Euribor will lead official rates higher. This can increase the actual cost of funds (based off Euribor) before any official ECB rate increase is announced. So for example, in the US at present, 3m $ Libor is over 0.3% above the official Federal Reserve funds rate. The next consideration is the level of volatility you can tolerate when projecting out your interest cost. The role of the markets is to make prices available to those who want certainty on the Euribor rate into the future. So the Euribor forward curve at any given point in time represents the market s best estimate of your future interest cost. However, markets will adjust in real time to any new information that changes the likely future path of official interest rates. The chart below illustrates the movement in the Euribor forward curve at three different intervals from September 2016 to date. By staying on a variable rate you stand to gain if the actual path of 3 month Euribor follows a lower trajectory than what is currently projected by the Euribor forward curve. You also avoid the risk of being over-hedged in the event you repay a portion or the full outstanding principal of the loan early. However, hedging covenants aside, you do need to have sufficient confidence that market volatility will remain within your tolerance range. You are accepting the risk of running an unhedged exposure to interest rates over the term of the loan. Source: Market Data Bloomberg, June 2018 6
Solutions 2. Paying Fixed Fixed Rate Loan / Interest Rate Swap Agreeing a fixed rate loan, or paying the fixed rate on an interest rate swap (IRS) will generally achieve the same economic objective, fixing the interest cost on your loan at a pre-determined level. However, given the current situation of negative Euribor rates in the Eurozone, an interest rate swap is not an appropriate hedging solution if you have a Euribor floor in your loan agreement. However, with a fixed rate loan (FRL), the hedging element is embedded in the loan itself. An interest rate swap is a derivative contract that runs independently to the loan, so the loan and the swap contract hedging the loan are separate. Under an interest rate swap, both parties agree to exchange cash flows based on the difference between a pre-agreed fixed rate and Euribor, over a schedule of dates throughout the term of the loan. The fixed rate is a construct of today s forward curve pricing. So by hedging, you are locking in the current forward interest rate outlook, insulating your business from any adverse scenarios not reflected in current forward market pricing. So, if interest rates rise exactly in line with current projections, (excluding any hedging credit spread) economically you should be no better or worse off by paying the fixed or variable rate. If interest rates rise sooner, or to a greater degree than currently anticipated you are protected. Agreeing to forgo variable for a fixed rate does carry the opportunity cost that interest rates may not reach the levels currently anticipated. When entering into an Interest Rate Swap it is important that you review your Loan Facility and ensure that the floating flows of the swap do not create a mis-match if your Loan contains a Euribor/LIBOR Floor (minimum rate). By hedging, you are locking in what the consensus of market participants believe today about the future path of interest rates. This provides for a first ECB rate hike toward the end of 2019 with rates to rise at a steady pace thereafter to a destination rate of 1% in 5 years. The decision to fix does not necessarily mean taking a strong market view; it s about achieving a certainty of interest costs that is appropriate for your anticipated future debt profile. A policy to fix 50% of debt could be considered a neutral stance as any rate moves on your variable debt will be offset by your portion of fixed debt. Are these assumptions within your desired interest cost budget or tolerance level? Hedging will enable you to remove interest rate risk from further consideration, allowing your business to get on with doing what you do best. Source: Market Data Bloomberg, June 2018 7
Solutions 3. Interest Rate Cap An Interest Rate Cap is a derivative contract that provides protection against interest rates rising above a certain agreed level, the Cap Strike rate. It is similar to an insurance product in that a premium is paid by the buyer of the Cap to the Bank in return for receiving payments in the future if rates go above the strike rate. At the beginning rollover period (generally matching the borrowers loan payments) the underlying Euribor rate is compared to the Strike rate. If Euribor is at or below the Strike rate there are no payments, but if Euribor is above the agreed Strike then the Bank will pay the difference between Euribor and the Strike rate to the Cap holder. The amount of premium paid will be determined largely by 3 factors; the Strike rate, the Term of the Cap and the underlying market volatility. A lower Strike rate, longer term or higher implied volatility will increase the premium payable and vice versa. The benefit of a Cap is that it allows the borrower to avail of favourable rate movements while still having protection in place in the event rates move higher. It gives the borrower a maximum cost of funds that will apply to their loan. no additional break costs in the event of early termination. This is of particular concern to borrowers who are uncertain as to whether they will hold the debt for the full duration of the loan; they can be hedged without the fear of a negative mark to the market that could arise from fixing for the full term via a FRL or IRS. When choosing the appropriate Strike, the rule of thumb is the lower the Strike the greater the protection, but also the higher the premium. Choosing a high Strike may be a cheap alternative and satisfy a Hedging Covenant, but it may only provide protection against the most adverse rate rises. Another advantage of the Cap is that the Bank selling the Cap usually will not require a credit line thus the borrower is not necessarily tied to its lender. However as it is a derivative contract the standard derivative on-boarding requirements apply (MiFID, EMIR, KYC/ AML, potentially an ISDA). Source: Market Data Bloomberg, June 2018 Because the premium is paid upfront when the Cap is purchased there will be *All prices above indicative only for illustration purposes 8
Solutions 4. Interest Rate Swaption An Interest Rate Payer s Swaption is a derivative contract which gives the borrower the right but not the obligation to enter into an interest rate swap (IRS) at a future point in time, in return for paying an upfront premium. It is used to lock in a known maximum cost of funds at a future date for an agreed tenor. They may be Cash or physically settled. If Cash-settled and the option is In the Money, at expiry the Mark-To-Market (MTM) of the underlying swap is paid to the option holder. A physically-settled swaption will result in the holder entering into an actual swap with the option seller. The amount of premium paid will be determined largely by 3 factors; the Strike rate, the Term of the option and the underlying market volatility. A swaption is typically used to hedge a borrowing requirement at some stage in the future. It gives greater flexibility than entering into a forward starting IRS where you are obligated to enter into the swap regardless of whether you draw the loan. If the hedge is not required and rates fall in the interim period leading up to expiry, the option will expire without any further payments, thus avoiding any potential unwind cost associated with a vanilla IRS. If the hedge is not required and rates rise in the interim period leading up to expiry the option can be cash-settled and the buyer receive the MTM of the underlying swap. Alternatively, if the loan draws but rates have fallen in the interim period the option will expire, with the premium lost, but the borrower can now avail of lower rates to hedge should they wish to do so. Swaptions can also be used where there may be an option for the borrower to extend the term of the loan, for example in a Property Loan where the loan can be extended from 5 to 7 years upon renewal of a tenancy agreement. The borrower may choose to hedge the first 5 years via one of the methods above but put a swaption in place for the optional 2 year period. The premium on a swaption will tend to be lower than a Cap premium for hedging the equivalent debt, as there is greater flexibility with the Cap. Given it is a more complex product it would tend to be more appropriate for the more professional/sophisticated borrower. CLICK HERE for full product description of an Interest Rate Swaption 9
Case Study Situation n It s the 28th June 2016, a borrower with core US Dollar debt wants to pre-hedge the interest rate exposure on a $10m notional amount for 5 years beyond the term of their existing credit facility. n Their existing credit facility is due to expire in 2 years time, 28th June 2018. n Today s 3m $ libor (as at June 2016) is 0.65%. n The current 5 year $ swap rate (as at June 2016) with a forward start of 28th June 2018 is 1.29%. Exposure: The borrower wishes to protect against this 5 year $ swap rate moving higher in 2 years time. Solution: The borrower requests a 5-year fixed rate payer swaption on a notional amount of $10m, to expire 28th June 2018, with a strike rate of 1.50%. The premium payable for this option is $200,000. On a notional amount of $10m, every 1 basis point movement in the 5 year rate has a value impact of $4,900. So the premium payment of $200,000 should be considered in the context of the potential number of basis points the 5y swap rate could move over the next 2 years. Result: As per illustration below, US interest rates moved significantly higher from June 2016 to 2018 than what was projected by the Libor forward curve in June 2016. On the 28th June 2018 the borrowers swaption strike rate of 1.50% expired over 130 basis points In-The-Money. This resulted in a cash settlement to the borrower of c. $615k to offset the increase in their 5 year interest cost above 1.50%. * All prices and values quoted above are for illustrative purposes only. Source: Market Data Bloomberg, June 2018 10
Case Study In Summary: While the timing of the next rate increase from the ECB is open to debate, market consensus is that we have reached the bottom of the cycle as regards official ECB rates. Thus we believe it is an opportune time to proactively examine your debt and put in place a strategy to manage the cost of this debt going forward. Choosing the right hedging product: FIXED RATE LOAN INTEREST RATE SWAP INTEREST RATE CAP INTEREST RATE SWAPTION UPFRONT PREMIUM PAYABLE NO NO YES (Deferred payment possible) YES ABILITY TO BENEFIT FROM FAVOURABLE MOVES NO Rate is fixed NO Rate is fixed YES YES SUITABLE FOR EURI/LIBOR FLOORED LOAN YES NO YES YES Cash settled NO Physical settlement CREDIT LINE REQUIRED YES YES NO NO Cash settled YES Physical settlement Once you have established the quantum, repayment profile and tenor of your debt we look forward to discussing the appropriate hedging strategy that best suits your needs. Please CLICK HERE for further information on managing interest rate exposure 11
Contact: Ciaran Cash Corporate Treasury Risk Solutions Ciaran.cash@boi.com Tel: +353 76 6244283 Edward Preston Head of Corporate Interest Rate Risk Management Edward.preston@boi.com Tel: +353 76 6244154 Q. Do you have any questions specific to your business? Please don t hesitate to get in touch following the contact details above. Also, sign up to receive our regular market updates direct to your inbox Daily market update FX Monthly report click here DISCLAIMER This document has been prepared by Global Markets Dublin ( GM ), a business unit within The Governor and Company of the Bank of Ireland ( BOI ), for information purposes only and GM is not soliciting any action based upon it. GM believes any information contained on the document to be accurate but GM does not warrant its accuracy and accepts no responsibility, other than any responsibility it may owe to any party under the European Union (Markets in Financial Instruments) Regulations 2017, as may be amended from time to time, and under the Financial Conduct Authority rules (where the client is resident in the UK), for any loss or damage caused by any act or omission taken as a result of the information contained in this document. No prices or rates mentioned are bids or offers by GM to purchase or sell any currencies, securities or financial instruments. Except as otherwise may be specifically agreed, GM has not acted nor will act as a fiduciary, financial or investment adviser with respect to any currency, derivative or other transaction that it has executed or will execute. Any decision made by a party after reading this document shall be on the basis of its own research and not be influenced or based on any view expressed by GM in this document or otherwise. This document does not address all risks. Any party should obtain independent professional advice before making any investment, trading and/or hedging decision. Any expressions of opinion reflect current opinions as at July 10th 2018. This document is based on information available before this date. BOI accepts no responsibility or liability for the accuracy or validity of any third party content referenced herein. This document is property of Bank of Ireland Global Markets. The content may not be reproduced, either in whole or in part, without the express written consent of a suitably authorised member of GM staff. Bank of Ireland is regulated by the Central Bank of Ireland.