Geistesblitz / Publications
19. July 2019
In the March issue, we had already adressed the US interest rate environment and the inverse yield curve. In the meantime, its negative steepness has intensified due to negative news. A significant slowdown in economic growth is feared for 2020. Political crises are not losing momentum, while the benefits of the corporate tax reform fade out. Inflation remains low (PCE core rate 1.6%). For this reason, US Federal Reserve Chairman Jerome Powell has repeatedly declared the FED’s propensity to ease interest rates.
For example, in the current interest rate environment it is cheaper for the time being to switch to the lower 5-year swap rate given a variable financing based on the 3-month USD Libor. But how long would this advantage last? Corporate clients with USD interest rate exposure are asking themselves how numerous these rate cuts might be and when the FED might turn course and thighten the reigns again. Is a plain-vanilla interest swap the right solution in this situation?
This edition of the Geistesblitz presents the “Cancellable Double-Swap”; an opportunity to reduce the interest rate considerably. In return, the bank is granted the right to terminate the interest hedge prematurely after one year. If it decides to waive the cancellation right, the notional amount is doubled.
Market Overview (July 17th 2019):
|3-month USD Libor:||2.3025% p.a.|
|5-year CMS rate:||1.8160% p.a.|
|Alternative 5-year Swap:||1.9000% p.a.|
|Interest difference (5 years – 3 months):||0.4025% p.a.|
|Alternative 4-year Forward Swap (starting in 1 year):||1.8300% p.a.|
The following chart shows the evolution of the 5-year swap rate, the 3-month USD Libor and their interest difference over the last 5 years.
USD interest optimization with “Cancellable Double-Swap”
Your client has a financing requirement of USD 5 million for the next 5 years. The financing is based on the 3-month USD Libor. Your customer expects falling money market rates, but is uncertain about both timing and intensity. He has no firm opinion on the future development of swap rates. He is considering a 5-year swap at 1.90% p.a. in order to improve his current interest rate by approx. 0.40% p.a. immediately. However, he is open to alternatives.
Your client receives the 3-month USD Libor for the next 4 interest periods (1 year) and pays a subsidized fixed rate of 1.59% p.a. in return. At the end of the year, the bank has the right to terminate the swap. If it waives the cancellation right, the swap will continue for the next 4 years at the given conditions. In this case, the swap notional amount doubles. This behavior is reflected in the “Cancellable Double-Swap”.
Indicative terms and conditions (July 17th 2019):
|Maturity:||5 years from spot|
|Client receives:||3-month USD Libor|
|Client pays:||1.59% p.a.|
Cancellation Right: The bank has the right to cancel the swap at the end of the first year. If it does not exercise this right, the notional amount of the swap is doubled.
Benefits and risks from the client’s perspective
In a nutshell
The new Geistesblitz “Cancellable Double-Swap” gives your client the opportunity to fix his currently variable interest rate for one year at a level well below the variable reference rate as well as the 5-year swap rate. After the first year, the strategy will either be terminated by the bank or continued at this level – well below the current forward swap rate – with double the notional amount. As a result, the client optimises his interest rate for at least one year. Afterwards, he continues to be hedged at these conditions or the strategy is terminated and your client has to decide between hedging at future market levels or remaining financed on a variable basis.
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.