Market data provided in this post was accurate as of the time of publication, (2 p.m. ET on March 16, 2020), but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.
The past month (and the past two weeks in particular) has provided the most volatile and concerning set of market conditions since the 2008 financial crisis. During the past 30-day period, we have witnessed a ~25% decline in the S&P (officially becoming a bear market in a record 15 trading days), the 10-year Treasury touch an all-time intraday low yield of 0.3363%, and the Federal Reserve announce two emergency rate cuts, together totaling 150 bps, cutting the lower bound of the Fed Funds target rate to 0%. With this backdrop, we’ve seen significant impacts on the transactions that we execute for our clients and, more broadly, changes in our considerations when speaking with clients about their interest rate risk and capital markets activity. While market conditions in the near-term are likely to remain volatile, we’d like to take this opportunity to catch our clients up on the past few weeks and bring to the forefront some of the key considerations we believe all CRE borrowers should keep in mind when thinking about rate risk and capital strategy in this environment.
The primary driver of the rapidly declining market sentiment has been concerns about the impact of the coronavirus on the U.S. and global economy. This broad concern has been punctuated by more specific concerns with respect to continued availability of corporate credit and potential distress in oil and oil adjacent industries, given the rapid decline in oil prices. The “worst-case” scenario describes a bleak picture with multiple causal factors that feed into one another: an extended coronavirus pandemic keeps workers and consumers home for some time, contracting both production and consumption (with spending in retail and hospitality sectors particularly curtailed); corporates need to draw down on bank lines of credit and other funding sources and some oil-related firms default on debt; and the combination of these factors results in tightening credit conditions and broader corporate distress.
As shown below, key market indicators have followed the development of this narrative, with declines in the yield on the 10-year Treasury and S&P 500, and an increase in the cost of insuring against corporate credit default accelerating in the past two weeks as coronavirus has spread globally and begun to impact the day to day lives of U.S. and European populations. Saudi Arabia announced on March 8 that they would begin flooding the market with an additional 2.6 million barrels of oil per day, driving down oil prices.
From a monetary policy perspective, the Fed has responded with its two emergency cuts (50 bps on March 3 and another 100 bps on March 15), has announced the provision of $1.5 trillion in additional liquidity to short-term funding markets, has essentially renewed quantitative easing with a commitment to purchase at least $500 billion of Treasuries and $200 billion of MBS in the coming months, and has cut the rate at which it will lend to its member banks to achieve reserve requirements from 1.25% to 0.25%. President Trump has declared the coronavirus a national emergency. To date, though, this policy response has not calmed markets. While the Fed’s actions have alleviated some stress in the credit markets, they’re unlikely to fully address the longer-term impacts of consumers and workers remaining at home for the coming weeks. At this point the market is focused on further details of Trump’s plan to combat the spread of coronavirus and delivery of fiscal stimulus from Congress.
As we’ve been discussing these conditions with our clients, several key themes, conditions, and considerations have emerged when considering interest rate risk, risk mitigation, and capital strategy:
- Widening bid-ask spreads: Over the past week, Chatham has observed reduced liquidity and widening bid-ask spreads for the bread-and-butter derivative products (caps and swaps) that our clients use when electing to hedge interest rate risk. This has been less consequential for swaps—while trader offer levels (before credit/profit mark-up) have widened to 2-3 bps in many cases (they’re typically tenths of a bps) the overall decline in base rates has made up for this many times over. It has been much more consequential for caps, with several dealers suspending pricing at different points this past week, and cap pricing increasing even as rates have fallen.
- Interest rate swaps: As longer-term rates have hit all-time lows and 1-month LIBOR swap rates remain below current LIBOR, we’ve seen many clients looking to convert floaters to fixed via swaps in situations where their mortgage lenders or unsecured lenders can offer them. This can often make sense, but we’ve seen many clients rush to transact without considering:
- Prepayment risk: Swaps create the possibility of a prepayment penalty, the risk of which should always be evaluated. We encourage CRE borrowers considering swaps to reach out so we can quantify this risk and suggest structures for mitigating it.
- Documentation provisions: Swap documents, if not properly negotiated, can create “backdoor” default provisions for the underlying loan.
- Swap pricing: While base swap rates are near all-time lows, borrowers should still negotiate the mark-up that the provider adds to the rate, and look for independent confirmation at execution of the base rate to which this mark-up is added, particularly given the wide bid-ask spread. In a rush to trade, we worry that clients may leave more on the table than typical, with awareness of this being lost in the overall low level of rates.
- LIBOR floors: Most CRE loans are structured so that LIBOR cannot fall below 0% (or sometimes as high as spot LIBOR or even higher) for purposes of calculating interest expense on the loan. When swapping such a loan, borrowers need to weigh the cost (via a higher rate) of including the floor in the swap vs. the risk of leaving it out and seeing their “fixed” rate start to increase if LIBOR does fall below the floor. Intuition on this cost/benefit comparison is often limited, so we highly encourage clients swapping loans with LIBOR floors to reach out to us.
- Swap valuation volatility: Some borrowers, particularly REITs, open end funds, and other GAAP filers, need to report the value of their swap on their financials. In volatile markets, borrowers may see this valuation change significantly quarter-over-quarter. Depending on reporting requirements, this could impact earnings (absent the application of hedge accounting) or quarterly fund returns.
- Potential alternatives: In speaking with clients that have been anxious to fix their floaters with swaps, we have found that many want to do so while also believing rates will fall further. Oftentimes there are benefits to locking in a fixed-rate even if rates may continue to fall, but we encourage clients to keep in mind a good rule of thumb—when hedging, swaps perform better when rates subsequently stay flat or rise, while caps perform better when rates subsequently continue to fall. For borrowers that want to electively hedge, they may consider purchasing caps or buying down strikes on existing caps as liquidity for those markets comes back. For borrowers with non-zero LIBOR floors in their loans, this may be the best way to achieve a fixed-rate profile.
- Floors in loans: In addition to the interaction between swaps and loan LIBOR floors mentioned above, we’ve observed that many of the more than 200 clients on our debt management platform have loans with LIBOR floors that are now “in-the-money” with actual LIBOR below their loan floor rate. This essentially fixes the rate on that loan until such time as LIBOR increases.
- Forward hedging: Low swap and treasury rates have also led many clients to look at forward hedging future fixed-rate financings, with the hope of locking in low base rates for permanent financings they expect to close in the coming months or even years. While this can be an effective way to manage this risk, we encourage clients to factor in potential floor rates on all-in coupons (which may make forward hedges expensive if rates fall—the forward hedge would settle with a payment to the hedge provider without a corresponding reduction in the loan rate) and increases in lending spreads, which can’t be forward hedged with typical interest rate derivative products. Clients looking to hedge against increasing prepayment costs if rates fall need to be more cognizant of the basis risk between swap rates and Treasury yields.
- LIBOR-Fed Funds disconnect: As mentioned above, one of the key narratives right now is the health of credit markets. When these markets function normally, LIBOR is highly correlated with the Fed Funds rate, with LIBOR tending to move up and down in conjunction with hikes/cuts from the Fed. This past Friday, March 13, however, we saw 1-month LIBOR reset up 10 bps from the day before, even as the market-implied probability of further rate cuts from the Fed increased (note: the Fed wound up cutting rates farther, faster). Why? Post-crisis, the method for setting LIBOR involves factoring in bank commercial paper and CD rates, which have been widening as credit markets have tightened in the past few weeks. This basis is an important indicator of the health of the corporate credit market. As it widens, CRE borrowers will see less benefit in their own borrowing costs from the Fed cutting rates.
As market conditions evolve, we will continue to reach out with updates on what we’re seeing. In the meantime, please don’t hesitate to reach out to your Chatham representative with questions on any of the themes above or about market conditions generally. We also encourage you to attend our debt valuations webinar on March 18 at 2 p.m. ET, where we will be sharing our observations on how the current market is impacting lending rates.
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. 20-0069
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