The implications of negative interest rates in the UK

March 22, 2020 Gregory Curtis

Market data provided in this post was accurate as of Friday 20, March 2020, but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.


Following the Bank of England’s initial 50 bps cut, GBP swap rates fell to all-time lows with the 5-year swap reaching 0.29% and the 10-year swap only one basis point higher at 0.30%. Rate expectations have since rebounded despite a further 15 bps cut last Thursday, with the 5-year swap rate now back at 0.51%.

In the U.S., the Federal Reserve has also taken drastic action, cutting rates by 150 bps over the last two weeks, which brings the Fed Funds closer to 0.00%.

Negative interbank rates have been the norm for several years in continental Europe and Japan, as illustrated in the chart below, but so far have been avoided in the UK and the U.S.

Historical interest rates

Source: Bloomberg, 20 March, 2020
 

However, whether looking at existing debt/hedging facilities or new facilities, borrowers should be conscious of the prospect of negative interest rates in the near future.

Historical implied 3-month GBP LIBOR

Source: Bloomberg, 20 March, 2020
 

Borrowers with 0% floors in their facilities should be aware—particularly when hedged by way of a vanilla swap. In such cases, there is potential for a mismatch in cash flows if interest rates turn negative as demonstrated by the flowchart below:

Swap and loan cash flows

In normal markets when LIBOR is positive, borrowers pay LIBOR and the margin on the debt facility and receive LIBOR and pay the fixed swap rate to the swap counterparty—LIBOR is cancelled out. However, when LIBOR turns negative and there is a 0% LIBOR floor in the debt facility, negative LIBOR does not offset the margin and the borrower must pay the negative LIBOR to the swap counterparty in addition to the fixed payment amount under the swap contract. This creates a LIBOR mismatch between the swap and debt facility and effectively increases the pre-margin cost of funds in line with the level of negative LIBOR.

To mitigate this potential risk, borrowers can purchase interest rate floors—ideally 0.00% floors. The 0.00% interest rate floor pays the borrower the difference between 0.00% and the negative rate and so compensates for this increased cost of funds—thereby ensuring a fixed cost of funds in a negative interest rate environment.

However, the interest rate floor comes at a cost. The borrower can choose to either pay upfront in the form of a premium or embed the costs into the existing swap rate. In normal market conditions, the latter is the usual route borrowers would take. However, given the current market is far from normal, this might require some negotiation with the bank. The key point to make is that, by buying back the floor, the borrower improves the position for the lender as this puts a limit on the mark-to-market, no matter how negative rates become.

The below grid shows the current 0.00% LIBOR floor pricing on a £25m notional for a range of tenors:

LIBOR floor pricing

Should you have any questions on the above, or other market impacts of the recent movements, we are here to assist in any way we can.


Disclosures

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. 20-0083

About the Author

Gregory Curtis

Gregory works on the Real Estate team at Chatham where he is focused on advising clients on their interest rate, inflation, and foreign exchange risk through derivative structuring.

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