LPA-Geistesblitz 5/2018
Geistesblitz
23. May 2018

LPA-Geistesblitz 5/2018

Variabilisation of a fixed-rate financing using a “Cancellable Receiver Swap with Cap”

Initial Situation

In an earlier edition of the „Geistesblitz“ we discussed the increase in fixed-rate financing.1 The interest of corporate customers in alternatives to a variable bank loan is rising. Fixed-rate bank loans, promotional loans (low-interest loans from public sector banks), corporate bonds and promissory note loans (“Schuldschein-Darlehen”) are profiting from this development.

The decision for a “Schuldschein-Darlehen” or corporate bond does usually not occur due to the preference of the issuer for a fixed rate. Both financing vehicles are available with floating rates as well. Thus, if they bear a fixed rate this is mostly owed to the investor’s preference for fixed rates.2 By leaving the investor the decision which variant to choose, the issuer surrenders sovereignty over its interest rate mix  in the sense of a mixture of fixed and variable interest rates.

In case of a fixed-rate bank loan or promotional loan the fixed rate might be unintentional. A need for action arises, should the increase in fixed-rate financings lead to a considerable deviation from their target profile. The current Geistesblitz “Variabilisation of a fixedrate financing using a `Cancellable Receiver Swap with Cap´” is an attractive way for customers to subsequently adjust their interest rate mix.


Market Overview overview (March 16th 2018):
3

6-month Euribor:   -0,2720% p.a.
7-year swap rate:    0,7440% p.a.

The following chart shows the performance of the 6-month Euribor and the 7-year swap rate over the last 5 years.

 

Cancellable Receiver Swap with Cap

Product description:

Your client enters into an interest rate strategy with a 7-year maturity receiving a fixed rate of 2.00% p.a. to serve a fixed-rate financing with 7 years remaining. In return, your customer pays the 6-month Euribor plus an interest spread of 1.35% p.a. The interest rate of your customer is limited to 4.50% p.a. by a cap.4 At mid-term – after 3 years and 6 months – the bank has the sole right to cancel the strategy.

Indicative terms and conditions:

  • Notional:    e.g. EUR 10M (no amortization)
  • Duration:    7 years from today
  • Frequency: semi-annually

Benefits and risks from a client perspective:

Benefits:

  • In spite of a new variability in the interest rate, your client is protected against an increase in the 6-month Euribor i.a. by more than 3.15% p.a.
  • As long as the receiver swap is not cancelled, the customer is given the opportunity to participate in a stable, falling or slightly rising 6-month Euribor.
  •  Your customer is able to restore his desired interest rate mix.
  • Based on current market data, the interest rate of your customer is approximately 1.08% p.a.5, a saving of approx. 0.92% p.a. compared to the existing fixed rate of 2.00% p.a.

Risks:

  • The maximum rate of the strategy of 4.50% p.a. exceeds the existing rate of 2.00% p.a. by 2.50% p.a.
  • Your client will pay an interest rate spread in addition to the 6-month Euribor which increases his interest rate against the reference rate by up to 1.35% p.a.
  • The variabilisation of your client’s interest rate is only temporary. If the bank cancels the strategy after 3 years and 6 months the interest rat is 2.00% p.a. once again.

In a Nutshell

The Geistesblitz „Variabilisation of a fixed-rate financing using a `Cancellable Receiver Swap with Cap´“ shows your customers a way to partially re-adjust their interest payments by increasing the variable portion and restore the desired interest rate mix. Despite the increase in the variable interest rate, he is still hedged by a maximum interest rate. In case the bank exercises its cancellation right of the strategy, the client returns to his original fixed rate.

This strategy is another facet showing the possibilities of separating liquidity management and interest rate management. Liquidity man-agement can continue to take place via the most appropriate financ-ing form in each specific case. In interest rate management, the de-sired interest profile – such as a target interest rate mix – is achieved by means of complementary strategies.


If you are interested in the March 2017 edition of the Geistesblitz please contact us via jan-henning.becker@l-p-a.com
Another advantage is the avoidance of negative reference rates and associated mitigation procedures (i.e. Euribor floors).
Swap rates: 6-month Euribor (semi-annually) vs. fixed rate (annually)
Should your client wish to waive the interest cap, the interest spread declines by appr. 0.08% p.a. to 1.27% p.a.
Interest rate of the client: 1.0780% p.a. = -0.2720% p.a. + 1.3500% p.a.

About the author
Jan-Henning Becker

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.

Jan-Henning Becker
Senior Manager

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Jan-Henning Becker
Senior Manager

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Jan-Henning Becker
Senior Manager
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