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:
- 5-year CMS rate:
Alternative 5-year Swap:
Interest difference (5 years – 3 months):
- Alternative 4-year Forward Swap (starting in 1 year):
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
Indicative terms and conditions (July 17th 2019):
5 years from spot
- Client receives:
3-month USD Libor
- Client pays:
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
- Your client reduces his interest rate for one year considerably. The
subsidized fixed rate undercuts the current level of the reference
interest rate as well as the swap rate of a 5-year hedge strategy.
Compared to the current 3-month USD Libor, the interest rate is approx.
0.71% p.a. lower. Relative to the alternative 5-year swap rate of 1.90%
p.a., the interest rate drops by 0.31% p.a.
- If the swap continues beyond the first year, your client is hedged
at a fixed rate that is 0.24% p.a. lower compared to today’s alternative
4-year forward swap of 1.83% p.a.
- During the first year, your client can no longer participate in
falling USD interest rates. This is the case for further 4 years, if the
bank does not terminate the interest rate strategy.
- The right to cancel the swap after the first year lies exclusively
with the bank. If the swap is terminated, the client is once again
exposed to an interest rate risk. Otherwise, the notional amount of the
swap is doubled.
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.