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The implications of negative interest rates

The implications of negative interest rates

Gregory Curtis Real Estate March 2020
*All market data and rate references as of Friday 20 March, 2020*

Following the Bank of England’s initial 50bps cut, GBP swap rates fell to all-time lows with the 5-year swap reaching 0.29% and the 10-year swap only one basis point higher at 0.30%. Rate expectations have since rebounded despite a further 15bps cut last Thursday, with the 5-year swap rate now back at 0.51%.

In the U.S., the Federal Reserve has also taken drastic action, cutting rates by 150 bps over the last two weeks, which brings the Fed Funds closer to 0.00%.

Negative interbank rates have been the norm for several years in continental Europe and Japan, as illustrated in the chart below, but so far have been avoided in the UK and the U.S.

Source: Bloomberg, 20 March, 2020

The Sterling current forward interest rate curve is also flat. This may provide borrowers with an opportunity to achieve additional tenor in their debt facilities without incurring a significant increase in borrowing costs. However, whether looking at existing debt facilities or new facilities, borrowers should be conscious of the prospect of negative interest rates in the near future.

Source: Bloomberg, 20 March, 2020

Borrowers with 0% floors in their facilities should be aware—particularly when hedged by way of a swap. In such cases, there is potential for a mismatch in cash flows if interest rates turn negative as demonstrated by the flowchart below:

When LIBOR turns negative, borrowers no longer receive the negative LIBOR on the debt facility but must pay the negative LIBOR under the swap. This increases the pre-margin cost of funds in line with the level of LIBOR.

To mitigate this potential risk, borrowers can purchase interest rate floors—ideally 0.00% floors. The 0.00% interest rate floor pays the borrower the difference between 0.00% and the negative rate and so compensates for this increased cost of funds—thereby ensuring a fixed cost of funds in a negative interest rate environment.

However, the interest rate floor comes at a cost. The borrower can choose to either pay upfront in the form of a premium or embed the costs into the existing swap rate.

The below grid shows the current 0.00% LIBOR floor pricing on a £25m notional for a range of tenors:

Should you have any questions on the above, or other market impacts of the recent movements, we are here to assist in any way we can.


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