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The pre-hedging conundrum and the rising popularity of swaptions
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The pre-hedging conundrum and the rising popularity of swaptions

Rhona Macpherson Weekly bulletin July 2019
Debt extensions and beyond

As GBP swap rates continue to slide, borrowers are exploring the virtues of pre-hedging potential future debt requirements. If borrowers are tempted, what is the best strategy?

Many recent debt facilities have been structured with commitments to lend for the first three to five years and include options to extend the debt under the same terms. This optionality allows lenders to offer more attractive debt terms in these uncertain times. From the borrowers’ perspective, however, it introduces the dilemma of whether to hedge the debt extension as well as the committed facility. Increasingly borrowers are not only opting to hedge the period of the debt extension, they are considering hedging even further out.

Although GBP swap rates are not quite at the historic lows witnessed shortly after the EU referendum, borrowers still see the current environment as a good opportunity to lock in future funding costs. The inverted yield curve makes swaps look particularly attractive, with quarterly swap rates up to five years currently below the three month Libor fixing.

In contrast, the inverted yield curve has made interest rate caps less attractive as the breakeven rate (the average Libor fixing over the period of the cap that would be required for the cap to be more economic than a swap) has slumped. Indeed, the average Libor fixing would need to fix below the current three month rate for lower strike caps (sub 1.25%) to be more economic than the equivalent swap.

UK rate cut in the balance

The UK economy has been more resilient than forecast, although the better-than-expected growth during the first quarter of the year has largely been attributed to stockpiling ahead of the UK’s expected departure from the EU in March. Still, labour markets are relatively robust, although consumer confidence has fallen. It’s broadly expected that a no-deal Brexit will be accompanied by a base rate cut. That said, BoE Governor Mark Carney observed that financial markets had virtually ignored the possibility of a smooth Brexit and warned that a favourable outcome could lead to rate hikes.

Elsewhere, financial markets are expecting further monetary stimulus, pricing in rate cuts from both the Fed and ECB. Futures are pricing in at least a 0.25% cut from the Fed this month, and as much as 0.30% from the ECB over the next 12 months amid concerns over the global economy, which has suffered from protracted trade tensions. In China, momentum has drained out of the economy, and Germany’s growth is at its weakest for a decade.

Pre-hedging tools

Without the underlying debt, or committed facilities, borrowers are mostly limited to option-based products to hedge their anticipated interest rate risk. Although the cost of using caps has fallen, longer dated caps are still comparatively expensive. Meanwhile, swaptions (options to enter into a swap on a future date at a pre-set fixed rate) are growing in popularity. Even if the borrower does not ultimately want to enter into a swap in the future, if the swaption is “in the money” at expiry, the value can be used to subsidise an alternative hedging strategy.

Among the attractions of option based strategies are flexibility and lack of break costs should interest rates either fall or remain at very low levels. It’s worth remembering that this is not the first time UK rates have appeared to be at bargain levels for borrowers to swap out their risk. Indeed, there are plenty of borrowers with tales of being burnt in the past by the cost of unwinding interest rate swaps. With so much uncertainty, putting some form of option based pre-hedging in place would now seem the prudent approach.

Economic data releases

Wednesday 10th July

  • UK Balance of payments
  • UK GDP MoM
  • UK Construction Output
  • UK Industrial production
  • UK Manufacturing production
  • US FOMC minutes
  • US Wholesale inventories

Thursday 11th July

  • UK Bank of England Financial Stability Report
  • US Inflation data
  • US Jobless claims

Friday 12th July

  • Euro Industrial Production
  • US Producer Price Index

For more information, please contact Rhona Macpherson, Associate Director at JCRA, at rhona.macpherson@jcrauk.com.

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