Market data provided in this post was accurate as of 12:00 PM ET on Monday, April 27, 2020, but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.
In our March 23 market update, we discussed the tightening credit conditions created by the COVID-19 crisis, some of the implications for CRE investors, and what the Fed was doing to alleviate them. With the passage of a month, shelter-in-place orders and temporary shut-downs still underpin the reality and gravity of the coronavirus and its impact on the country and world as a whole. Concern and uncertainty continue to characterize economic activity, or the lack thereof. While local, state, and federal governments work to abate the broader impacts of the virus, the actions undertaken by the Federal Reserve and the U.S. government appear to have improved some of these tightening credit conditions.
This update will summarize the continued actions of the Fed over the past few weeks, how those actions have flowed through to some of the indicators of credit conditions important to CRE borrowers, and examine how these changing conditions are impacting interest rate caps, one of the common interest rate risk mitigation tools used in conjunction with CRE debt.
Since Chatham’s update on March 23, the Fed has taken a number of additional actions to directly support liquidity in the credit markets:
- April 6, 2020: The Fed implements a temporary repurchase agreement facility for foreign and international monetary authorities (FIMA Repo Facility) to support overnight repo operations, collateralized by Treasury securities.
- April 9, 2020: The Fed takes additional actions to provide up to $2.3 trillion in loans to support the economy through:
- The Paycheck Protection Program Liquidity Facility (PPPLF);
- Purchases of up to $600 billion in loans through the Main Street Lending Program (MSLF) in support of small- and mid-size businesses;
- Expanding credit flow by up to $850 billion in credit backed by $85 billion in credit protection through the Primary (PMCCF) and Secondary Market Corporate Finance Facilities (SMCCF), and Term Asset-Backed Securities Loan Facility (TALF);
- Up to $500 billion in lending to states and municipalities through the Municipal Liquidity Facility.
- April 14, 2020: Commercial Paper Funding Facility (CPFF) provides up to $100 billion to purchase 3-month corporate, asset-backed, and municipal corporate paper.
While these actions have not yet translated into an improvement in credit availability for CRE investors, indicators do suggest they have improved credit availability for banks, a necessary (if not sufficient) condition for a return to normalcy in CRE borrowing. Although still not back to pre-COVID-19 levels, the FRA-OIS spread (a closely followed number reflecting the spread of short-term bank borrowing costs to the Federal Funds Rate) has trended downward since peaking in the first half of March. Bank CDS spreads (which measure the cost of insuring against a bank defaulting on its debt) have also trended down, signaling greater confidence that banks are funded in a way to support their debt service.
Of more direct benefit to CRE borrowers, and as evidenced in the charts below, recent weeks showed dramatic drops in base rates used for floating-rate CRE debt. Tightening credit conditions in March caused the SIFMA index to surge, spiking by almost 300 bps from the previous week. Since then, the implementation of commercial paper facilities, along with the Municipality Liquidity Facility and generally improving credit conditions, have abated the sharp increase in SIFMA, bringing it back in line with its historical relationship to LIBOR. Furthermore, the relief to the short-term funding market stresses (and their impact to the pricing of bank commercial paper) has similarly impacted LIBOR, moving it closer to the Fed Funds Rate and returning to its historical relationship to this Index. This has eliminated the somewhat counterintuitive circumstance where LIBOR was higher than longer term LIBOR swap rates (discussed in our March 30 market update), though shorter term swap rates are still pricing in the probability that LIBOR will continue to decline.
Current market conditions have created some interesting dynamics for pricing of interest rate caps, a product which CRE borrowers commonly use to hedge against increases in 1-month LIBOR (for more information on caps please see our explanatory post). As swap rates (and more recently spot LIBOR) have declined, we’ve seen some cap structures improve in pricing while others have not, as shown in the chart below. If swap rates reflect what the market is pricing in for future LIBOR resets (and thus the likelihood that a cap will pay out to its purchaser) the decline in rates in over the past few months begs the question: if rates are dropping and projected to stay low, why are some caps declining in price while others are still as expensive as before?
The answer to this question lies in understanding that there are two drivers for a cap with a given term and strike rate:
- Interest rates, specifically their future expectations depicted on the forward curve; and
- Interest rate volatility, the statistical measure of dispersion (the amount of movement in the underlying rate)
The first component is intuitive—since a cap pays out if rates rise above the strike rate, the higher expected future rates are the more expensive it will be. We call the rate to which a cap is most sensitive its “key rate”, which is really just the swap rate with a term corresponding to the term of the cap. The key rate for a 3-year cap above is simply the 3-year swap rate.
The second component is less intuitive but just as important. Interest rate volatility, as it pertains to caps, can be thought of as the market’s confidence in the key rate. If the key rate describes market expectations for future LIBOR settings, volatility describes the extent to which the market believes actual rates will deviate from the path implied by the key rate. Higher volatility implies a greater likelihood that rates will spike higher than those implied by the key rate, resulting in a larger payout by the cap seller. Consequently, as interest rate volatility increases, cap pricing will also increase.
When we factor in this fuller understanding of cap pricing, the story of the past few months becomes more ambiguous—though swap rates (i.e. key rates for caps) have fallen, volatility has increased.
While cap pricing is susceptible to movements in both volatility and rates, the relative movement in pricing depends on where a cap strike sits relative to the key rate. For caps with higher strikes, changes in volatility play a more significant role in pricing. For caps with lower strikes, the key rate has a larger impact on pricing.
This explains the changes in cap pricing we’ve seen over the past few weeks. With rates falling but volatility increasing, lower strike caps (whose pricing is dominated by rate movements) have fallen in price while higher strike caps (whose pricing is more dominated by changes in volatility) have seen no decline or even some increase. In practice, this has translated into both opportunities and frustrations. We’ve seen many CRE investors take advantage of declining prices for lower strike caps to electively buy down the strikes on existing caps (in some cases to the level of loan floors, essentially fixing the rate on the debt) or purchasing low strike caps across larger portfolios of debt. Other investors (particularly those buying higher strike caps like those required on Agency debt) have been disappointed to find that their cap pricing hasn’t declined with rates as they would expect, or worse: may even have gone up.
We’ll continue to provide updates as we see market conditions evolve and implications for our CRE clients change. In the meantime please feel free to reach out to your Chatham representative if you'd like to further discuss any of the themes above.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0134
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