The historic lows in EUR and GBP rates have led investors to favour the certainty of interest rate swaps.
Low interest rates have encouraged a spate of refinancing activity, with many investors increasing the maturity of their debt. The historic lows in EUR and GBP rates have led investors to favour the certainty of interest rate swaps. In the UK, this is sometimes complicated by punitive termination/early repayment provisions imposed on longer tenor debt – and in this case swaptions provide a good alternative for hedging refinancing risk. Despite the economic and geopolitical uncertainty, volatility is pricing significantly lower than at any point last year, meaning that option-based strategies represent relatively good value.
Euro swap rates are falling deeper into negative territory and hitting further ‘all time lows’. Close attention must therefore be paid to any “floors” in a facility’s definition of Euribor, as their impact on the hedging strategy and overall cost of funds can be substantial. Possibly the cleanest solution to the complications posed by such floors is to negotiate them out of the proportion of the facility to be hedged. Unsurprisingly, this is most easily achieved if the issue is raised early on in the debt process.
In recent months, we have worked on a number of securitisations that have come to market. The hedging, and in particular the associated downgrade language, has a significant economic impact in these transactions. Downgrade language has a significant impact on future bond ratings, meaning that many issuances tend towards the most onerous provisions. Investors looking to finance via securitisations should consider such costs early in the process, as we have seen many instances where the cost of the downgrade language is a multiple of the underlying cost of the interest rate derivative.
On the FX side, our clients range across the capital spectrum, but real estate debt funds have been a particular areas of growth. Their cross-border mandates and focus on IRR means they are very cognisant of the damage FX movements can inflict on returns. It is therefore key to ensure there is an optimal hedging program in place to manage this risk – and, just as importantly, that the efficiency of the program can be clearly measured.
We continue to see significant appetite for inflation-linked, longer-dated income. This has led to an increase in commercial ground rent activity, with investors looking to income strips to institutions. Naturally, such transactions have triggered an increase in enquiries for inflation hedging. In these cases, it is important to bear in mind that security will be required to support an inflation derivative over and above that demanded by the debt. Once again, incorporating hedging considerations during the early stages will make it much easier to arrive at an optimal solution.
With regards to LIBOR Transition, the direction of travel is increasingly towards “compounded SONIA in arrears”, with a spread applied in an attempt to avoid any transfer of value. The main risk remains an inconsistency between the fallbacks on a borrower’s debt and derivatives, which could lead to mismatches for hedged borrowers.