Introduction
Over the past decade, management of interest rate risk has predominantly involved embedded fixes on fixed-rate loans and typically long-term fixed rate funding from debt capital markets (DCM).
Hedging was a relatively benign topic when rates were at record lows. Following the substantial increase in interest rates over the past two years, HAs may fear ‘locking-in’ at relatively high rates.
The downwards sloping yield curve has increased attention on varying funding tenors as well as hedging alternatives.
Interest rate risk still needs to be managed and with lower capital markets issuance volumes, HAs are increasingly looking at bank hedging options as these risk management tools return to the fore.
In this article, we explore some of the different hedging strategies HAs can consider on a ‘standalone’ basis using the International Swaps and Derivatives Association’s (ISDA) master agreements, to mitigate risk and optimise treasury positioning.
We do not comment on embedded hedging and/or an increasing trend for some banks requiring this to be transacted in loan linked ISDA agreements.
Interest Rate Swaps
Interest rate swaps are one of the most common and simple hedging options.
A swap removes interest rate variability on a floating rate loan, exchanging a variable interest rate for a fixed one over the duration of the swap.
Executing a swap has the advantage of mitigating interest rate risk, but it is important to note there is a cost and there are complexities that need to be considered.
Swaps are typically executed with banks under ISDA master agreements (with a credit support annex) and collateral is typically required by the bank counterparty in the event interest rates fall.
From a collateral perspective, there is normally an unsecured threshold above which you allocate a pool of security and if this provides insufficient cover there would be a need for cash collateral.
Availability of unencumbered assets and efficient use of security, plus potential exposure to cash calls, are key considerations.
Swap rates are currently highest at the short end, with the Sterling Overnight Index Average (SONIA) forwards peaking in 12 months, before gradually falling to long-term levels of circa four per cent.
An HA needs to consider when to start the swap, as forward starting swaps can avoid the SONIA peak altogether.
For example, while the seven-year swap rate might be 4.4 per cent, a seven-year swap starting in two years could offer a more favourable four per cent.
In this example, interest rate risk would apply to the HA for the first two years and so funding requirement, liquidity and interest exposure should be assessed before entering a transaction.
Interest rate caps – mitigating downside risk
Interest rate caps offer an alternative hedging option, permitting borrowers to protect themselves from rising interest rates while retaining the benefit if rates fall. Caps are typically executed with banks under ISDA master agreements.
Under an interest rate cap, the borrower’s interest rate remains floating but only up to a specified cap level, above which they are effectively fixed.
The borrower pays a premium for this protection, typically as an upfront cost, though some banks may allow this to be deferred and spread over the term of the cap.
The cap level (strike) and tenor determine the premium paid and can be set based on how much interest rate increase can be absorbed by the business plan. The higher the cap level is, the less interest rate protection and hence the cheaper the premium.
A key benefit of caps that have been paid upfront is if rates rise above the strike or the interest rate volatility increases, it can become a financial asset, however if rates or volatility fall, there is no liability.
For this reason, and unlike for an interest rate swap, the credit risk of the borrower is not a consideration when a bank assesses pricing for a standalone cap. Therefore, often credit approval processes are faster (or not required) and notional appetite is greater.
It is important for borrowers to carefully balance and assess the required cap level and associated premium versus forecast interest rate exposure.
Interest rate collars – balancing risk and premium
To reduce the premium associated with an interest rate cap, a common strategy is for a borrower to enter an interest rate ‘collar’, where an interest rate floor of the same duration is entered into to offset the cap’s cost.
By optimising the combination of floor and cap levels, a borrower can significantly reduce the cap premium paid.
It is possible for a nil premium to be achieved, depending on risk tolerance and specific hedging objectives.
It is important to note that a collar is similar to swaps in some respects, and can be a liability if the floor becomes worth more than the cap.
Conclusion
Given the ability to manage interest rate risk more flexibly, it is perhaps no surprise that interest rate swaps, caps and collars are gaining prominence.
As with any hedging product, decisions should be made following careful analysis of a loan portfolio, the risks associated with the product, and the impact of future scenarios such as prepayment costs if hedging were closed out prior to maturity.
ISDA agreements can provide a number of benefits, but they also come with risks that require careful consideration.
For more information on any of the solutions discussed, please contact Jonathan Spearing.
The article was originally published in Social Housing Magazine in August 2023.
