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Hedging in a Falling Rate Environment

August 25, 2019

Last Week This Morning

  • 10 Year Treasury tested 1.62% but fell again and closed out at 1.535%
    • German bund had a benign week, closing at -0.68%
      • The entire German yield curve is negative
    • Japan 10yr unch at -0.24%
      • Japan’s yield curve is negative out to 15 years
  • 2 Year Treasury fell significantly and closed at 1.533%
  • LIBOR at 2.14% and SOFR at 2.09%
  • Yield curve inverted at times Wednesday, Thursday, and Friday
  • The President of the United State wondered aloud if the Chairman of the Federal Reserve is a bigger enemy than the president of China, and somehow that wasn’t his craziest tweet of the day
  • Speaking of Powell, his Jackson Hole speech was largely a dud and he didn’t say anything to suggest a change in current policy (mid-cycle adjustment vs the beginning of an easing cycle)
    • Despite his non-committal speech, markets still have a 100% probability of a cut at the September 18th FOMC meeting
    • The market has odds of two cuts by the October 30th meeting at 72%
    • Powell blamed Trump the trade war, not interest rates, for the risks confronting the economy
  • China announced tariffs on an additional $75B of US goods
  • That same US President “hereby ordered” US companies to look for alternatives to China and to bring their business home to the US, then tweeted that the latest round of tariffs will be 15% instead of 10%, and concluded very presidentially with, “Thank you for your attention to this matter!”
  • Any hopes of tackling the real issues with China, namely IP theft, is fading because of all this noise
    • China likely interpreted the announced delay in tariffs for Christmas shopping as weakness
    • Xi is just going to wait until the November 2020 elections before having meaningful discussions unless Trump gets desperate

 

Hedging in a Falling Rate Environment

I can’t spend another newsletter talking about an inverted yield curve, so let’s examine some possible hedging solutions for the new rate environment.  We’ll start with the basics and transition into the more structured ideas as we go.

 

Just Float

From the Department of Let’s Not Overthink It, just float.  Floating rates are headed lower with minimal chance of heading higher anytime soon.

 

Hedge a Portion

Hedge something less than 100%.  That’s it.  Literally.  Diversify your risk, dollar cost averaging, etc.

 

Negotiate Those Floors!

We’ve been banging this drum since January, but keep negotiating those floors.

 

Buy a Cap

Caps with terms 3 years and less are getting back to 2012-2015 levels, basically just transaction costs.

Lower strikes are getting less and less expensive, so you can buy a cap at 2.0% or 2.50% for pretty reasonable costs.

We are seeing far more long-term caps than usual.  Customers are spending the extra money to buy 5-10 years caps as a portfolio hedge.

 

Just Fix

If you have a 10 year hold period with a low likelihood of prepayment from sale or refi, it’s hard to argue with locking in right now.   Just be aware of how a potential prepayment penalty could impact your ability to refinance during a downturn.

 

Shorter Term Swaps

Swaps normally make the most sense for long term holds as alternatives to permanent debt; however, when the market is pricing in an aggressive drop in rates, shorter term swaps can make sense.

3 year swap        1.40%

With LIBOR at 2.14%, this is a savings of 0.74% right out of the gate.

But something even shorter could simply be viewed as getting some immediate savings and providing budget certainty.

12/31/19 maturity           1.90%

12/31/20 maturity           1.55%

 

Collar

I’m not usually a big fan of collars.  They are frequently sold as alternatives to caps, but from a credit perspective they behave more like swaps than caps.  Borrowers typically have to execute with the lender and they have prepayment penalties.

But they could make more sense in this environment.  Here’s are a couple of 3 year collars.  We pick the cap strike and solve for the floor that results in no cost to purchase.

Cap        2.00%

Floor      0.86%

Or, raise the cap and lower the floor.

Cap        2.50%

Floor      0.65%

 

Forward Starting Swaps

You agree that rates are headed lower over the next couple of years, but 10 years is a long time.  You could lock in a swap today that begins in the future.  Float between now and then, then automatically roll into the fixed rate.  For example, here’s a swap that starts today vs a swap that starts in 3 years.

9/1/19 – 9/1/29               1.35%

9/1/22 – 9/1/29               1.38%

I feel like a Sarah McLachlan SPCA commercial.  “For just 1bp a year, you can forward lock a fixed rate.”

 

Step Coupons

We can structure the interest rate to accommodate cash flow needs.  Nothing says the rate has to be 1.35% for 10 years – it just needs to average 1.35% for 10 years.

If you want to maximize cashflow on the front end, depress the rate on the front and amortize that over the backend.  For example:

9/1/19 – 9/1/22               0.95%

9/1/22 – 9/1/29               1.60%

Or maybe you have solid leases in place for the next 3 years but are more worried about where we will be in 2022 and beyond.  You could actually force the rate higher over the near term in exchange for backend savings.

9/1/19 – 9/1/22               2.00%

9/1/22 – 9/1/29               1.15%

These can be structured in a variety of ways to accommodate your objectives, the net result just needs to roughly average the current swap rate.  Try to think of these as cashflow plays, not rate arbitrage plays.

 

Cancellable Swaps

Because there is so much sentiment about falling rates, prepayment flexibility is becoming a bigger concern.

In general, we are not huge fans for imbedding prepayment flexibility into the swap rate and paying for it through a higher rate.  Options are much tougher for borrowers to price (without us) and swap desks benefit from the lack of transparency on these.  We can put together analysis to help compare the concrete higher interest cost vs prepayment scenarios if you like to illustrate how much rates would have to fall in order for the potential prepayment savings to offset the increased interest expense.

With that caveat out of the way, the current rate environment has made cancellable swaps expensive.  The market is so concerned with the possibility of falling rates that being able to prepay without penalty is going to cost a lot.

10 year swap                     1.35%

Cancellable 9/1/24              1.70%

That’s a lot of additional interest for the ability to prepay after the 5th year.  That being said, the 1.75% fixed rate is where 10 year swap rates were a month ago.  In other words, if you were underwriting a deal at 1.75% last month, you’ve basically picked up a cancellable feature for free.

But you can also structure a cancellable swap the other direction – give the bank the right to cancel.  Borrowers tend to hate to give banks control like this, but if you are comfortable with the rate risk and/or actually expect to prepay anyway, this could make sense.

10 year swap                     1.35%

Cancellable 9/1/24              1.00%

You pick up 0.35% in savings per annum for the next five years.  In exchange, the bank gets to terminate the swap any time after year 5.  They will exercise this right if fixed rates are above 1.00%…so yeah, that could definitely happen.  But if you expect to prepay anyway, maybe saving 0.35% for the first five years is worth it.

 

Swaptions

For those with refi’s a few years from now and aren’t refinancing, swaptions could help avoid the dreaded “I missed the dip” feeling.

As a reminder, swaptions are the right, but not the obligation, to pay/receive a fixed rate.  If you want to hedge against 10 year rates moving higher over the next three years, you can buy the right to pay a fixed 10 year rate in September 2022.  Here’s some sample pricing assuming $25mm.

You buy the right to pay 1.50%     $1.2mm

Or raise the strike, and pay less.

You buy the right to pay 2.00%     $680k

Fast forward to 2022, if 10 year swap rates are below the strike, the option expires worthless.  Alternatively, if 10 year swaps are above the strike, you would exercise and receive the present value difference between the strike and the actual 10 year swap rate.

Swaptions can also be used to hedge against a drop in rates to prevent a prepayment penalty from getting worse.  We highlighted this last month (thanks Sean!), but here’s an example of a $25mm loan with a 12/1/19 settlement (eg, you plan on buying/selling in December and are worried about the penalty increasing between now and then).  Let’s say this particular loan has three years remaining, so you are trying to hedge against 3 year rates falling.

Strike     1.30%

Cost       $125k

If rates fall, the prepayment penalty increases, but the swaption gains value that offsets that increase. We also see clients crafting language that helps split this cost with the buyer/seller.

 

This Week

G7 summit will give Trump an opportunity to rally the international community around us…jk.  He’ll push an America-first agenda, which for some reason doesn’t go over as well with foreign leaders as it does at his rallies.  I assume he’ll be cheerleading Russia’s need to rejoin the G7 as well.  Every Republican leader from my childhood must be so proud.

Economic data headlines will be Durable Goods, Consumer Confidence, a revision to the most recent GDP print, and Consumer Spending.