Interest optimisation of a KfW promotional loan

Interest optimisation of a KfW promotional loan

Initial Situation

For some time now, the continuing low interest rate environment in the  eurozone has been drawing market participants’ attention to longer maturities of 10 years and beyond. In this context, KfW’s more favourable (re-)financing options are often integrated into a comprehensive, tailor-made offer by the intermediary bank.

In addition to an attractive client interest rate, the German promotional bank KfW offers a redemption bonus. For example, in the case of KfW promotional loans for real estate a redemption bonus of 5% to 15% is granted under the “Energy-Efficient Construction” programme (No. 153), and as much as 7.5% to 27.5% under the “Energy-Efficient Renovation” programme (No. 151).

The amount of this redemption bonus is a very welcome support, reducing the redemption amount (in case of a 5% redemption bonus only 95% of the loan have to be repaid). However, it does not necessarily meet the applicant’s needs in the best possible way. For this reason, KfW is considering to further reduce the currently slightly positive interbank interest rate for the intermediary bank into the negative range. However, due to technical issues this will most likely not be the case before autumn this year. Presumably, this will enable a significant reduction in the client interest rate. But how can considerable positive liquidity effects be achieved right from the start?

In the Geistesblitz we use the example of the financing of a new construction project with 50 micro-apartments to present the possibility of using a 5% redemption bonus – which would otherwise be only fully effective at maturity (in this case after 10 years) – to effectively relieve cash flows from the start as part of an interest optimisation.

Market Overview (06.01.2020):
  • 1-month Euribor: -0,4500% p.a. 
  • 10-year Swap (client’s rate): 0,1007% p.a. 
  • Interest difference (10 years – 1 month): 0,5507% p.a. 
The following chart shows the performance of the 1-month Euribor and the 10-year swap rate over the last 10 years.                    
Figure 1: Evolution of 1-month Euribor and 10-year EUR swap rate over time

10-year interest optimisation of a KfW promotional loan

Product description:

Your client creates a property with 50 micro-apartments. To finance these, he uses the KfW programme “Energy-Efficient Construction” (No. 153). He is able to utilise the current upper limit of EUR 100,000 per housing unit and thus obtain a KfW loan of EUR 5 million. The client opts for a 10-year term with a 10-year fixed-interest period and bullet repayment. Since the project is expected to achieve the KfW standard “Efficiency House 55”, he also plans to receive a redemption bonus of 5% (EUR 5,000 per unit or EUR 250,000 for the entire project).

We assume that the redemption bonus will be granted in 3 years (after completion of construction and successful certification). In this case, it reduces the outstanding loan volume and the interest payments by 5% from this point in time. However, the main liquidity effect of the redemption bonus is only achieved at maturity when the client has to repay only 95% of the notional amount instead of 100%.

Our proposal is to use this redemption bonus to reduce cash flows in the first years of construction and ramp-up by reducing interest rates. As a result of the additional interest optimisation concluded with the intermediary bank, the interest rate will fall from 0.75% p.a. to 0.00% p.a. in the first three years. This “Bonus Phase” is followed by a “Cap Phase” until maturity, in which the client pays the 1-month Euribor plus an interest premium of 1.10% p.a., but pays a maximum of 0.75% p.a. (known as fixed rate in the KfW loan). Thus, after a guaranteed interest relief, the client has the opportunity to participate in possibly still low interest rates through a conditional interest relief.

In return, the client “waives” the redemption bonus. At maturity, he repays 100% of the notional amount to the transferring bank, which passes 95% on to KfW. The intermediary bank retains the remaining 5% to forward it to the interest optimisation in order to finance the previous interest relief for the client. The transfer of the redemption bonus from the client to the bank is purely synthetic. The underlying KfW loan remains unaffected by the synthetic loan adjustment.

Indicative terms and conditions:

Maturity: 10 years starting 31.01.2020

Payments: monthly, act/360

Client receives: 0.75% p.a. (30/360 analogous to KfW)

Client pays Bonus Phase (years 1 to 3): 0.00% p.a.

Cap Phase (years 4 to 10): 1-month Euribor plus 1.10% p.a., max. 0.75% p.a.

Redemption bonus:  The client “waives” KfW’s redemption bonus in favour of the intermediary bank, by contributing it to the interest rate optimisation. At maturity he repays the original notional amount of 100% (95% to amortize the loan and 5% for the interest optimisation).

Reference notional: The client receives from the swap transaction the interest rate of the KfW loan on the notional amount reduced by 5% after year 3 (expected accounting of the redemption bonus). However, he continues to pay its interest rate on the original
notional amount of 100%.



Figure 2: Cash flows during the 10-year term and at maturity

The following chart shows the difference in cash flows between an isolated KfW loan and a KfW loan with interest optimisation as described above over the 10-year term. On the left hand side a guaranteed interest saving for 3 years is shown. In the following years there is a potential interest saving for 7 years (the extent of which is unknown today). On the right hand side (at maturity) the negative liquidity effect due to the 5% redemption bonus is shown.                      

       

Figure 3: Difference between cash flows with and without interest optimisation

Benefits and risks from a client perspective:

Benefits:
  • In the first three years (Bonus Phase), your client pays 0.00% p.a. instead of 0.75% p.a., achieves an interest reduction of 0.75% p.a. on the full notional amount and can therefore already collect 45% of the redemption bonus during the construction and ramp-up period of the project (0.75% x 3 years = 2.25% of the notional amount; the redemption bonus amounts to 5%).
  • In the following seven years (cap phase), the client pays the 1-month Euribor plus 1.10% p.a., but not more than the fixed rate of the KfW loan of 0.75% p.a.
Risks:
  • In favour of the Bank, your client waives the redemption bonus of 5%, which would otherwise be fully liquidity-effective at maturity (after 10 years). The 5% of the notional amount must also be paid if KfW’s redemption bonus does not materialise in case the required conditions for disbursement are not fulfilled.
  • In the cap phase, the client pays 0.75% p.a. on the original notional instead of the notional reduced by 5%. This corresponds to a waiver of an effective interest rate reduction of approx. 04% p.a. (or 5% of 0.75% p.a.).
Alternative strategy:

Instead of a Bonus Phase followed by a Cap Phase, a 10-year Bonus Phase would also be conceivable. In the case of a uniform interest rate, the client would receive 0.75% p.a. for 10 years (on the notional amount reduced by the redemption bonus) and pay 0.33% p.a. in return (on an unchanged notional amount). Doing so, the 5% redemption bonus would be transferred into a guaranteed interest rate reduction over the entire 10-year term.

In a nutshell

The new Geistesblitz “Interest optimisation of a KfW promotional loan” shows your client an opportunity to further reduce his already favourable KfW interest rate and thus realise a low interest burden early on during the term of the loan, without having to wait for KfW to implement lower client interest rates. In return, he passes on his redemption bonus to the transferring institution, which only takes considerable effect at maturity. The solution presented here is only one of many possibilities for a synthetic loan adjustment. Please contact us for alternative solutions, other KfW programmes or a change in the initial client situation.

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