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Case Study

Refinancing risks and the potential effect on IRR

Summary

Read a recent case study for one of our infrastructure clients, looking to hedge their interest rate exposure via a 35-year interest rate swap.

Background

  • Our client was purchasing an asset with a long dated, 35-year fixed revenue stream.
  • As is typical for this type of project the debt funding is sourced for the construction period (in this case 10 years) and then converts to the investment term.
  • To match the term of the interest rate exposure to that of the revenue stream, the debt is hedged via a 35-year interest rate swap.
  • The financial sponsor intended to refinance at the 10 year point, likely into a 25 year fixed rate bond issue (GoC + corporate spread).

Our approach

  • Evaluation of timing slippage on the refinancing, and repercussions for the targeted internal rate of return (IRR).
  • Detailed pricing analysis of the basis risk between swap spreads (which impacts the termination cost of the swap) versus the financing costs linked to a corporate bond spread.
  • Risk of swap spreads moving down relative to corporate spreads and jeopardising refinancing assumptions feeding into a reduction in assumed IRR at the time of the initial financing.
  • Ensure the swap rates (mid-rate and credit spreads) are managed appropriately.

Benefits

  • Our client obtained “at-market” swap executions and minimized swap credit spreads, therefore reducing the potential termination cost that may arise at the 10 year refinance point.
  • Our client is now able to manage the effect that a potential movement in swap spreads could have on IRR at the time of refinancing.
  • Our client’s IRR assumptions were fully supported by the market analysis we carried out and the risk evaluation appraisal of the refinancing point.

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Disclaimers

This material has been created by Chatham Financial Europe, Ltd. and is intended for a non-U.S. audience. Chatham Financial Europe, Ltd. is authorised and regulated by the Financial Conduct Authority of the United Kingdom with reference number 197251.