Pre-hedging future exposure to swap rates

Inflation has been in the spotlight over the last few months with UK RPI reaching 4.80% and expected to continue to rise to c. 5.80% in 2022, well above the Bank of England’s 2% target. Inflation in the EU has also exceeded the European Central Bank’s 2% target, with August EU CPI release reaching 3%.

A portion of the recent rise in inflation has been driven by rapidly increasing energy prices, and it’s unlikely that hawkish central banking policies will do much to provide relief on that front.

We are also seeing interest rate expectations push higher in the UK and the EU. The 5-year 3-month SONIA swap rate has climbed from 0.47% to 0.92% since the start of September with the 5-year 3-month EURIBOR swap rate also jumping by roughly 0.30% over the same period.

Although current UK interest rate swaps are already implying 2-3 rate hikes by the end of 2022, the gap between interest rate expectations and inflation expectations remains at unusually high levels as shown in the charts below.

The question as to whether the recent spike in inflation is transitory and short-lived or structural and sustained is subject to debate. Should high inflation sustain, it would be reasonable to expect a further increase in interest rate swaps and a “normalization” of the gap with inflation swap rates.

Borrowers are increasingly concerned about their exposure to higher interest rates beyond the term of existing financings, and look to explore how they might pre-hedge that future risk today, without locking into fixed rates.

Interest rate swaptions offer attractive value for borrowers keen on pre-hedging future refinancing risk. They offer a worst case pre-margin cost of debt while providing the flexibility to take advantage of lower interest rates should the anticipated increase in rates not come to fruition.

Because swaptions can be cash settled, they provide further flexibility on the "choice" of hedging strategy at the point of maturity in the sense that the borrower is not committed to a specific instrument or profile. They can use the payoff toward any strategy (such as an interest rate cap). Swaptions do require premium payment upfront, but don’t need a credit line with a counterparty, meaning borrowers do not need to rely on their lending bank to offer this product. Swaptions do not attract any breakage cost.

The recent spike in swap rates is a stark reminder of how fast investment returns can be eroded. A typical debt financing takes a few months to complete, and borrowers are completely exposed to a rise in interest rates between the time the acquisition is agreed and the moment the financing closes (or throughout a refinancing process). Short-term swaptions can be valuable in such scenarios where the economics are sensitive to increases in financing costs.

The tables below provide an indication of current swaption premiums (as a percentage of the notional hedged) and breakeven levels illustrating where interest rates would need to rise to before the purchase of the swaption pays for itself in lower interest costs. We have considered three scenarios with a range of strikes in each case:

• 3-month / 5-year: A swaption giving the option to enter into a 5-year swap at the strike level in three months
• 1-year / 5-year: A swaption giving the option to enter into a 5-year swap at the strike level in one year
• 3-year / 5-year: A swaption giving the option to enter into a 5-year swap at the strike level in five years

With the recent market volatility and rapidly changing environment, the ability to mitigate market risks can have a significant impact on deal certainty, deal rationale, and transaction economics. Whether investors are concerned about short- or long-term rises in interest rate swaps, there is real merit in considering swaptions as a hedging tool since they offer protection on future borrowing costs without involving any commitments and are cheaper than interest rate caps.

We are helping our clients navigate these difficult markets and assisting them to structure adequate hedging solutions. Please reach out to your Chatham representative if you have any questions or would like to discuss.