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|  Interest Rate Hedging
Niche Bridging Loans & Interest Rate Risk Management for Professional Landlords & Investors
Overview
The topic of interest rate hedging is becoming increasingly more discussed in current market conditions. Many borrowers have found themselves with no option other than to remain on a Lenders Standard Variable Rate (SVR), due to criteria, limited lending options and loan to value (LTV) restrictions narrowing the refinancing market to an unwelcome low. With Businesses and Landlords unable to adjust their borrowing exposure to a product or Lender to suit their business plan and attitude to risk, stand alone Interest Rate Management products such as Caps, Collars and Swaps become a suitable alternative. What is Interest Rate Hedging?
In brief: Interest rate hedging is minimising and maximising your exposure to interest fluctuations by entering into a financial derivative. When considering your residential, business or portfolio mortgage debt, different strategies will need to be applied that protect your exposure within a defined period. Why are you here?
If you wish to understand more about Interest Rate Risk Management Products and the options available to you please choose from the links below
If you already have specific requirements and would like a quotation or to speak to our Independent Analyst please contact us via email What's the next step?
You can either contact us directly for a no obligation quotation or use our Independent Analyst service to assist you in deciding what strategy to take. If it is outside business hours, please feel free to send your requirements via email and we will respond the next working day. Subscribe to our mailing list to get all of the latest informationInterest Rate Risk Management
Businesses who borrow over longer terms (five years plus) usually do so to invest in their assets or to consolidate shorter term borrowing. Taking advantage of longer term finance can help place businesses on a firm foundation, however, it can also expose them to risk if interest rates rise to levels that seriously affect their profitability. With this type of risk normally affecting businesses when they borrow longer term, it’s not surprising that there isn’t always a good understanding of the implications of this risk or of how it can be controlled. There are however a range of potential risk management solutions that can be integrated into your financing plans.
Taking a longer term view shows us that interest rates historically have been volatile, affecting the borrowing costs and profitability of businesses, many businesses wish to avoid this and look for greater certainty in cash flow planning and budgeting, seeking to protect themselves against a critical level of borrowing costs.
So, if you are borrowing longer term and are concerned about what might happen if interest rates rise, you are concerned about interest rate risk. It’s that simple…..
In all circumstances, the importance of considering a range of interest rate risk management (spread hedging) alternatives should be stressed as no single approach will suit all cases. A standard fixed rate won’t be the best solution for everyone and the key is to consider a range of alternatives and make a decision based on your individual requirements.
Businesses are becoming increasingly active in their use of interest rate management services with a common theme being the need for medium to long-term finance allied to a strong desire to eliminate uncertainty in financial performance. While taking advantage of longer-term finance places businesses on a firm financial foundation, it can also expose them to risk in terms of the uncertainty surrounding future interest rates. Interest rate risk management is an important element in longer-term financial planning.
The purpose here is not to attempt to provide potential solutions to specific interest rate risk management issues, rather it is to explain the building blocks of many of the interest rate risk management solutions used by businesses today. Interest rate management solutions are adapted to satisfy a client’s individual needs however at their core are a number of common building blocks such as caps, floors, collars and swaps which form the subject matter here. By understanding the basics of these products, their application to real life situations becomes clearer. Base Rate Cap A Base Rate cap sets a ceiling on a borrower’s interest rate costs. A cap takes the form of an agreement under which the Bank agrees to pay you the difference between the average Base Rate and the cap rate, where the average Base Rate is above the cap rate. Any payments due to you take place at preset times over the life of the cap. In return you pay the Bank a premium. This can be either up-front or in instalments.
Example Company XYZ has a £1 million 15 year borrowing facility with an agreed loan margin of 2% over Base Rate. (Assume the current Base Rate is 5.75%.) The company wants interest rate protection for 10 years of the 15 year term but does not wish to ‘lock in’ to a fixed rate, given their view that short term rates will decline. The company decides that interest costs above 9% would be difficult to sustain. <br><br>
Company XYZ draws down the £1 million loan and simultaneously buys a 10 year Base Rate cap with a cap rate of 7% vs 3 month average Base Rate.
(N.B. The loan margin of 2% needs to be taken into account when selecting the appropriate cap rate i.e. 7% Base Rate + 2% margin = 9% maximum rate to the customer.) There is a premium payable for this type of protection, which can be paid up-front or in instalments over the life of the cap. Features Interest rate protection. Most commonly, the buyer of a Base Rate cap is seeking to limit the risk associated with rising rates, while retaining the full benefit of declining interest rates. Unlike some other interest rate risk management products, the purchase of a cap does not ‘lock in’ the borrower to a fixed rate, and so if interest rates decline the benefits of cheaper funding are received.
Very flexible. Base Rate caps can be adapted to provide the level of protection required. The cap can be for a constant borrowing amount throughout the life or structured on a reducing or increasing amount. Likewise the cap rate can ‘step up’ or ‘step down’ to suit specific cash flow forecasts.
No credit line. If the premium is paid upfront, the seller of the cap has no credit exposure to the buyer, meaning that interest rate risk management can be implemented speedily.
Base Rate Collar A Base Rate collar is a combination of an interest rate cap (maximum interest rate) and an interest rate floor (minimum interest rate) and is used to obtain protection from adverse interest rate movements. The borrower is able to benefit from favourable rate movements within a pre-agreed range. The inclusion of the interest rate floor makes the premium for a Base Rate collar lower than that for a comparable Base Rate cap. In fact, a ‘zero premium’ collar can often be structured so that no premium payment is required.
Example
Company XYZ has a £2 million 15 year bank facility with an agreed loan margin of 2% over Base Rate. (Assume the current Base Rate is 5.75%.) XYZ wants interest rate protection for 10 years but does not wish to ‘lock in’ to a fixed rate, as they believe that short term rates will decline to a rate somewhere above 4.5%. From the forecast cash flow, they have decided that interest costs above 9% would be difficult to sustain and do not wish to pay an up-front premium for interest rate hedging
The customer draws down the £2 million loan and simultaneously purchases a £2 million 10 year Base Rate collar. This involves the purchase of a Base Rate cap with a strike rate of 7% vs 3 month Average Base Rate and selling a Base Rate floor with a strike rate of 4.5% vs 3 month Average Base Rate. (N.B. The loan margin of 2% needs to be taken into account when selecting the appropriate cap strike rate i.e. 7% Base Rate + 2% margin = 9% maximum rate to the customer; 4.5% Base Rate + 2% margin = 6.5% minimum rate to the customer.)
Features
Independent from underlying loan. A Base Rate collar is not a commitment to borrow. Therefore a separate decision can be made as to how and where to borrow, and how to manage interest rate exposure.
Certainty. If the base rate moves above the cap strike rate, payments will be made to the customer, thereby allowing maximum borrowing costs to be quantified. This allows the customer to produce more accurate budgets and cash flow forecasts. Unlike some other interest rate risk management solutions, the purchase of a collar does not ‘lock in’ the borrower to a fixed rate, and so the benefits of lower interest rates can be obtained. The floor sets a limit on the level of benefit received. If the base rate falls below the floor strike rate, payments will be made by the customer.
Low up-front premium. Compared to a base rate cap, the up-front premium payable can be reduced to improve the negative impact on short-term cash flow. Potential breakage costs Additional costs may be incurred in the event that the customer wishes to come out of this arrangement, based on prevailing market conditions, such as interest rates and market expectations of future interest rate changes. This could be the case where, for example, the asset financed is sold and the underlying borrowing is repaid early or re-scheduled.
Base Rate Swap
Base Rate swaps are used by a number of businesses to manage their interest rate exposures. The Base Rate swap provides a means of converting floating rate (Base Rate) debt to fixed rate debt. For the two parties involved, it is a contractual agreement whereby they exchange a series of payments based on different interest rate indices, but on a common notional principal. There is no exchange of principal, only an exchange of interest payments.
Example
Company XYZ has a £1 million 15 year bank loan with an agreed loan margin of 2% over Base Rate. (Assume the current Base Rate is 5.75%.) The customer wishes to fix their interest cost for a 5 year term as they believe that rates will rise over this period. The quoted fixed rate is 5% (plus loan margin 2%). They draw down the £1 million bank loan and simultaneously enter into an interest rate swap.
Features No up-front fee is payable. Unlike some other forms of interest rate protection (e.g. interest rate caps), there is no fee payable.
Very flexible. Interest rate swaps can be tailored to suit the borrower’s specific debt repayment profile.
Can be reversed at a future date. An interest rate swap can be unwound at the prevailing market rates to reflect changes either to the interest rate risk management strategy or underlying borrowing structure. Although this might result in a cost at the time of unwind, in this way a customer can, nevertheless, seek to change their interest rate management strategy depending on how their views on future interest rate movements have changed. Potential breakage costs Additional costs may be incurred in the event that the customer wishes to come out of this arrangement, based on prevailing market conditions, such as interest rates and market expectations of future interest rate changes. This could be the case where, for example, the asset being financed is sold and the underlying borrowing is repaid early or re-scheduled.
Notes
The following notes are important for those intending to proceed with a transaction.
Any hedging contract that you enter into with a Bank is a separate legal contract from any borrowing it may relate to. In particular, they may be terminated independently of each other and early termination of one does not automatically terminate the other.
The cost to you of the overall hedging structure and any borrowing is the sum of the cost of the borrowing and the net cost to you of the hedging contract, whether this is a swap, cap, collar or any other hedging structure.
If you are hedging an interest rate exposure: You will be exposed to interest rate risk if there is a mismatch between the start dates or end dates of the underlying debt and any interest rate protection. This mismatch may be caused by circumstances such as a deferred start to the agreed protection or alternatively by delay in drawing down the loan. You will be exposed to interest rate risk if there is a difference between the value of the debt that is to be protected and the notional principal of your interest rate contract. If you enter into an over-the-counter derivative transaction and decide to close out the transaction before its scheduled termination date, you may have to pay breakage costs. These will be calculated by reference to prevailing market conditions and include costs incurred by the Bank in terminating any related financial instrument or trading position. Please note that such break costs may be substantial. Where you enter into a derivative transaction for the purposes of hedging debt and you subsequently wish to repay the debt (whether through a refinancing or otherwise) or discharge all other obligations, you should be aware that it may be necessary to terminate the hedging transaction prior to its scheduled termination date and satisfy any liabilities that you have with the Bank with respect to such transaction (including break costs) before release of any security you have provided with respect to such liabilities. You are acting for your own account and will make an independent evaluation of the transactions entered into and their associated risks, and you should seek independent financial advice if unclear about any aspect of the transaction or risks associated with it and you place, or will place, no reliance the Bank for advice or recommendations of any sort. You should request the Banks terms of business.
The contents of this document are indicative and are subject to change without notice and are for information only and do not in anyway provide advice.
Benrandall.co.uk will not act and has not acted as your legal, tax, accounting or investment adviser or owe any fiduciary duties to you in connection with this, or any related transaction and no reliance may be placed on us for advice or recommendations of any sort. We make no representations or warranties with respect to the information, and disclaims all liability for any use you make of the contents of this document. Where the document is connected to OTC financial instruments you should be aware that over-the-counter derivatives (“OTC Derivatives”) can provide significant benefits but may also involve a variety of significant risks. All OTC Derivatives involve risks which include (inter-alia) the risk of adverse or unanticipated market, financial or political developments, risks relating to the counterparty, liquidity risk and other risks of a complex character. In the event that such risks arise, substantial costs and/or losses may be incurred and operational risks may arise in the event that appropriate internal systems and controls are not in place to manage such risks. Therefore you should also determine whether the OTC transaction is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances.
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