Geistesblitz 20/06

Geistesblitz 20/06

Temporary liquidity relief in the Corona crisis using a Step-Up Swap

Initial Situation 

The Corona crisis presents banks and their customers with new, difficult challenges. In recent weeks, all parties involved have been working closely together to bridge liquidity bottlenecks of the companies and soften the effects of credit agreement clauses.
Promotional banks like the German KfW are also providing Corona aid to companies under existing and new programmes. Although the possibilities are manifold, there is not necessarily something for every customer, as the following overview of possible restrictions shows. 

Figure 1: Possible restrictions of KfW Corona aid   

In cases where the wide range of possible Corona aids cannot be made suitable, a timely decision is mandated or only a flanking solution is sought, derivative solutions can be used. These offer the advantage that they can be tailored to the individual requirements of each company very specifically. This is where the new Geistesblitz comes into play. In the current issue of the Geistesblitz, we use the example of an existing synthetic fixed-rate loan to present the possibility of "taking the load off” with an individual solution. In this case, your customer's interest burden is temporarily eliminated for 2 years by means of a "Step-Up Swap".

Market Overview (11.06.2020)

  • 3-month Euribor: -0,3580% p.a.
  • 10-year EUR Swap: -0,1159% p.a.

The following chart shows the performance of the 3-month Euribor and the 10-year swap rate over the last 10 years.

Figure 2: Evolution of 3-month Euribor and 10-year EUR swap rate over time 

Step-Up Swap to optimise an existing interest hedge 

Product description: 

Your customer has an existing financing with a remaining term of 10 years. He pays the 3-month Euribor plus a financing margin of 1.00% p.a. In the past, he has concluded a fixed rate swap to hedge interest rates. In this swap, he exchanges his variable interest burden (incl. financing margin) for a fixed rate of 2.00% p.a. due to the higher interest rate level at the time.

Figure 3: A Step-Up Swap supplementing existing transactions

Our proposal is to eliminate the entire interest burden of 2.00% p.a. for a period of two years (interest rate 0.00% p.a.) in order to achieve a noteworthy liquidity relief. This bonus phase is followed by a compensation phase until the end of the term, during which the client pays an increased fixed rate of 2.60% p.a. The interest burden of the following two years is eliminated purely synthetically through the supplementary interest rate step swap. Both the underlying variable loan and the existing fixed rate swap remain unaffected and will continue to be serviced as before.

Indicative terms and conditions: 

  • Notional: i.e. 2.5 Mio. EUR
  • Maturity: 10 years starting 31.03.2020
  • Payments: quarterly, 30/360 
  • Client receives: 2.00% p.a.

    Client pays:  
  • Bonus Phase (years 1 to 2): 0.00% p.a. 
  • Compensation Phase (years 3 to 10): 2.60% p.a.

Figure 4: Quarterly cash flows in the bonus phase and the compensation phase

The following chart shows a comparison of the cash flows between the current "synthetic fixed rate" of variable loan and fixed rate swap (2.5 Mio. EUR each) over the 10-year term and the new solution of a supplementary Step-Up Swap as interest optimisation. With this interest swap there is a guaranteed interest savings for 2 years (as seen on the left-hand side) and afterwards a compensatory increase in the interest burden for the following 8 years.

Figure 5: Annual cash flows with and without interest optimisation

Benefits and risks from a client perspective: 

  • In the first two years your client pays 0.00% p.a. instead of 2.00% p.a. and can fully offset the existing interest burden. In the bonus phase, he achieves an annual liquidity relief of approx. EUR 50,000 (approx. EUR 100,000 in total). 
  • The existing loan and current swap remain unaffected by this temporary liquidity relief. 
  • No additional market price risk, because all future payments are known today. Any swap termination at a later date can be carried out at conditions largely known in advance. 
  • In the 8 years of the compensation phase, your customer pays 2.60% p.a. and thus a premium of 0.60% p.a. on his previous interest burden of 2.00% p.a. This equals an annual additional interest burden of approx. EUR 15,000.
  • The market value of the swap drops to approx. minus 4.80% at the peak (at the beginning of the compensation phase). Early termination would be associated with a corresponding one-off expense for the customer.

Alternative strategy:

In the preceding example, the current debt service consists exclusively of interest payments. The repayment occurs only at maturity. In the case of an amortising notional structure, a temporary deferment of amortisation payments – in addition to an elimination of interest payments – is fathomable. In the bonus phase, the customer receives the amortisation payments from the derivative in addition to the interest payments in order to service the existing loan. In return, once the bonus phase has expired, the customer makes payments to the derivative in addition to the normal payments to the loan in order to gradually reduce the deferred amortisation over the remaining term. The interest coupon of the compensation phase and presumably the required trading line will be higher. The existing loan and the current swap remain unaffected also in this case.

In a nutshell

The new Geistesblitz "Temporary liquidity relief in the Corona crisis using a Step-Up Swap" shows your customer a possibility to eliminate his existing interest burden of a (synthetic) fixed-rate loan for some interest periods. In the current Corona crisis he can thus regain room to maneuvre – independent of the Corona aids such as those from the KfW, for example. In return, the customer consents to pay a higher interest rate after the bonus phase. After the January Geistesblitz, the variant presented here shows a further section of the many possibilities of synthetic loan adjustment to meet the individual requirements of a company. For further possibilities of using derivatives for liquidity management beyond pure interest rate hedging, please contact us.

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