Negative interest rates add complexity to hedging decisions. In the current interest rate environment, Libor floors are common in floating rate loan agreements. Indeed, the majority of sterling denominated loans now have Libor floors, often struck at 0%. Certain hedging instruments that protect the borrower against rising Libor can introduce the risk of higher borrowing costs if Libor turns negative. This in itself is also a risk that can be hedged, and we’re noticing an uptick in the number of clients keen to explore possible solutions.
One of the most popular tools to hedge the Libor risk in a floating rate loan is the interest rate swap. Should this instrument be used to hedge a loan with a Libor floor at 0%, however, if Libor were negative, the borrower would be required to pay the negative Libor rate to the hedge counterparty but would fail to receive it back under the loan facility. This mismatch in cash flows would have the net effect of increasing the borrower’s cost of funds. There are other hedging instruments available that avoid this effect in a negative interest rate environment. The obvious one is the interest rate cap, which sets an upper limit for Libor. But interest rate caps, require a premium to be paid, so they may not suit everyone.
One solution would be to include a Libor floor on the floating leg of an interest rate swap. However, the cost of doing this has steadily increased in recent months. Currently, to include a 0% floor in a three year interest rate swap would add around 0.06% to the fixed rate, and for a five year interest rate swap the cost is more than double at 0.13%. Back in April this year, when swap rates were 0.50% higher, the cost to hedge a 0% Libor floor on a five year swap was closer to 0.05%.
So how worried should borrowers be about the risk of negative interest rates in the UK? The last few weeks have been a timely reminder of how volatile financial markets can be. During this period, traders complained that liquidity was as poor as in the weeks following the EU referendum, with markets hostage to “deal or no deal” rhetoric. It has been with this backdrop that borrowers have become more concerned about the potential for negative interest rates in the UK and are seeking solutions to remove the risk.
The likelihood of negative sterling rates
Previously, the consensus had been that sterling interest rates would not turn negative. But in this unpredictable environment, that is no longer a given. Just glance across at other regions. Last week saw the first 30 year German Bund with a zero coupon and negative yield, albeit with limited uptake. As it stands, Bank of England governor Mark Carney is not a fan of negative interest rates in the UK, but that’s not to say his successor will hold the same view. A no-deal Brexit may require radical actions.
That said, the market is still not convinced that Libor will turn negative in the UK, so many lean towards leaving the risk unhedged. But it’s a risky strategy and not one that everyone agrees with. We are now seeing more enquiries from our clients looking to hedge the Libor floor in their debt facility. Although the cost to do this has increased, given recent volatility an additional 0.13% on a five year interest rate swap may not be such a big price to pay for certitude.
For more information, please contact Rhona Macpherson, Associate Director at JCRA, at firstname.lastname@example.org.