What are interest rates?
Interest rates are the cost of borrowing money. For example, if a bank lends a borrower £10,000 for one year at an annualised interest rate of 3.00%, the borrower will pay back £300 per year in interest payments.
The bank will specify the basis upon which the interest cost will be calculated (e.g LIBOR, EURIBOR, UK base rate). This interest rate is what is described as ‘floating’ in that it will change based on market conditions. In addition to this ‘floating’ rate of interest, the total interest rate payable under a loan will also include a ‘fixed’ margin. For the purposes of this article, we are only focused on the floating rate component.
What are negative interest rates?
This essentially means that the bank will pay the borrower. Using the same example above, if the interest rate was -3.00%, the bank would pay £300 to the borrower in interest payments per year. Negative interest rates reward borrowers for borrowing and penalises savers for depositing money with the bank.
During times of economic uncertainty businesses would rather hold onto their liquidity instead of investing. As a form of monetary policy to stimulate economic growth, central banks reduce interest rates. When these rates (eg EURIBOR) fall below zero, central banks are in effect incentivising banks to lend more freely and in turn encouraging borrowers to invest and spend more as opposed to paying the banks to keep their deposit.
With the possibility of negative interest rates came the adoption of interest rate floors by lending banks to guarantee a return on their loans. If LIBOR rates for example were to fall below zero, the 0% floor prevents the bank from paying negative interest payments to the borrower on their loan.
Why could this be an issue for you?
A common derivative used by borrowers to hedge the floating interest rate risk on their loans is a swap. A swap involves an exchange of cash flows: the bank will make the floating leg payments and the borrower makes fixed payments at the swap rate. If the borrower’s loan is hedged with a swap, they could possibly end up paying the floating leg interest payments as well as the fixed interest payments if floating interest rates became negative. In this scenario the bank has included a 0% floor in the loan agreement but the borrower has not included a 0% floor for the swap.
This mismatch of interest rate floors can lead to a situation, in the case of negative interest rates, where the desired purpose of the swap for the borrower is eliminated. Instead of the swap serving as a hedging tool, the borrowing would end up paying ever increasing amounts of interest as floating rates became more negative.
What can you do?
There are options that can be explored to prevent this mismatch such as purchasing a 0% interest rate floor in conjunction with implementing the swap. Another possible option could be to work with the bank to put in a conditional floor on the loan that would only be effective on the portion of the loan that remained unhedged. However, this would need to be agreed as part of the negotiations over the terms of the underlying loan facility.
A couple of additional points to consider with respect to interest rate floors embedded into loan agreements are that firstly they are not always set at 0% and could be positive, eg 1%. In this scenario, if the prevailing swap rate is below this floor rate, the implementation of a swap would immediately result in an increased cost of funds for the borrower.
Perhaps more importantly, there are potential implications with the accounting treatment of any swap implemented against a loan including an embedded floor. Without the purchase of a floor to offset the one included in the loan could result in the hedging (in the form of a swap) being deemed to be ‘ineffective’, having implications on how the hedging (swap) would be accounted for.
We are FCA authorised to be able to advise all types of UK companies on hedging, so please don’t hesitate to contact us on any of the above for a chat.