The implications of negative interest rates in the UK

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.

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.

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.

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:

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:

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.