Pricing a foreign currency loan spread competitively
Summary
A EUR-denominated fund has an opportunity to make a mezzanine loan to a UK borrower. The prospective borrower can accept a five-year mezzanine loan in British pounds (GBP) at three-month Sterling Overnight Index Average (SONIA) plus 600 basis points. The fund has a minimum return target of 6% IRR in euros (EUR) and needs to consider the potential impact to returns from GBP depreciation against EUR. Can the fund offer the loan at a spread of 600 basis points or does the fund need a higher spread?
Loan details:
- Notional: GBP 100 million
- Tenor: five years
- Index: SONIA, subject to 1% floor
- Spread: 600 basis points
- Origination fee: 100 basis points
- Prepayment penalty: 3% in year one, 2% in year two, 1% in year three
- Amortization: partial with balloon repayment
Arriving at the answer can be a complex process. A natural starting point is to use this relationship: expected SONIA + [x] basis points spread – expected GBP-to-EUR hedging costs > 6%. For example, obtain the SONIA forward rates, model a EUR-GBP fixed-floating cross currency (XCCY) swap for the hedging costs, plug them into the equation, and see if [x] can be 600.
Alas, it is not that simple. The five-year hedging costs are high and that can make the loan spread uncompetitive, leading the prospective borrower to decline the loan. Why use the five-year hedging costs and lose the business if the borrower may repay early? In practice, the fund may hedge the currency risk with quarterly rolling forward contracts and since the three-month hedging costs are much lower, the loan spread can be priced more competitively. But a rolling programme typically does not hedge future interest and hedging costs reset at every roll in that programme. Under GBP depreciation and/or rising hedging costs, the realized return may fall below the 6% target. The fund cannot set the loan spread too low in case intervening factors lead to underperformance.
In general, there are three clusters of factors that interact with one another1, creating many possible outcomes. Table 1 shows examples of interactions that can produce a realized return of below 6%.
Table 1: Three clusters of factors that impact realized returns
How close to 6% or how much below 6%? The impact of these interactions can be quantified with a simulation model. Chatham custom-builds models for debt fund managers based on their loan specifics such as the amortization schedule, prepayment penalties, index, origination fees, etc. Different currency scenarios, including one-to-two standard deviation paths, and different hedging costs are available in the model for the manager to vary the currency environment. Two-to-three common hedging strategies are incorporated so that the manager can compare the relative pros and cons. The prepayment date can be selected in the model. The manager then inputs a loan spread and run a wide range of simulations to assess the risk of not hitting the minimum 7%.
Tables 2 and 3 are sample outputs from a model built for the above GBP mezzanine loan. Table 3 reports the project returns in EUR under 1 standard deviation GBP weakness and higher-than-expected hedging costs assuming different prepayment dates and loan spreads. It may or may not be feasible for the fund to accept the proposed 600 basis points proposed by the prospective borrower.
Table 2: Projected returns in EUR in different currency environments
Table 3: Projected returns in EUR under different loan prepayments
A sound understanding of the three clusters of factors that impact the returns of foreign currency loans, coupled with a robust simulation engine, can help debt fund managers be competitive in pricing their foreign currency loans without sacrificing risk management prudence.
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1 Leaving out the obvious underperformance due to borrower default.
Disclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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