Geistesblitz / Publications
25. March 2019
Storm clouds are brewing on the horizon of the US economy as well. The country appears to be in the final stage of the economic cycle. Thus, for short and medium term maturities the yield curve is partially inversed. Since mid-December, the difference between the 5-year swap rate and the 3-month USD Libor has been negative.
As a result, interest rate hedges for corporates with USD interest rate exposure have recently moved back into focus. In the current interest rate environment, it is more advantageous to hedge a variable financing at the lower swap rate from a short term perspective. The question of whether it is also the right timing for an USD interest rate hedge is answered by corporates – as is usually the case – very individually.
The Geistesblitz presents the “CombiSwap” (aka “CapSwap”); an attractive way for companies to limit their interest rate risk of a rising 3-month USD Libor for 5 years. In return, they neither have to forego participation in low 3-month USD Libor rates for the next fixing periods, nor do they have to accept a fixed rate higher than the 5-year swap rate.
Market Overview (March 22nd 2019):
|3-month USD Libor:||2.6098% p.a.|
|5-year CMS rate:||2.2630% p.a.|
|alternat. 5-year Swap:||2.3500% p.a.|
|alternat. 3.5-year Swap:||2.2800% p.a. (start: 28.09.2020)|
The following chart shows the performance of the 3-month USD Libor and the 5-year swap rate over the last 5 years.
USD interest hedge with “CombiSwap”
Your client has a financing requirement of USD 5 million for the next 5 years. He pays an interest rate based on the 3-month Libor. In the medium term, your client expects higher money and capital market interest rates and prefers a fixed rate. He is therefore considering a hedge using a 5-year swap at the current rate of 2.35% per annum. However, in view of the uncertainty of the short-term development of the 3-month USD Libor – in particular the possibility of a significant drop in the 3-month USD Libor – he would like to remain financed on a variable basis for the time being, and hedging only a maximum interest rate. However, he is not prepared to pay a premium for this hedge.
For the next 6 interest periods (1.5 years) your client will purchase a cap 2.79% p.a. on the 3-month USD Libor. For the following 14 interest periods (3.5 years) he hedges a fixed rate of 2.35% p.a., hence at the level of the alternative 5-year swap rate. These objectives are reflected in the “CombiSwap”.
Indicative terms and conditions
|Maturity||5 years from spot|
|Client receives||3-month USD Libor|
|Period 1 to 6 (Cap)||3-month USD Libor, max. 2.79% p.a.|
|Period 7 to 20 (Swap)||2.35% p.a. (fixed rate)|
Benefits and risks from the clients perspective
In a nutshell
The new Geistesblitz with the “CombiSwap” presents a possibility for your client to hedge his variable interest payments. A short term hedge using a Cap is followed subsequently by Swap. Your client initially continues to participate in possibly decreasing 3-month USD Libor rates. However, he neither has to pay a premium, nor does he has to accept a fixed rate higher than the 5-year swap rate.
Jan-Henning Becker is Senior Manager at LPA’s Distribution Advisory team. He has more than 10 years of experience in capital markets, having worked at a German investment bank before joining LPA. He is CFA charterholder and has earned the FRM certificate. At LPA, Jan-Henning focuses on consulting topics related to trading and sales of risk management products.