Cost of leverage in a volatile rate environment
Hedging and Capital Markets
Real Estate | Kennett Square, PA
SummaryAlong with a backdrop of rising interest rates over the course of the year, rate volatility has increased substantially. Treasury yields and swap rates at both the short and long end of the curve have exhibited significant variance in relatively short time periods (including overnight) as a result of market uncertainty around inflation and economic growth and the Fed’s policy decisions in response to these conditions. This has translated into greater interest rate risk on the cost of debt in the window between deal commitment and closing. This piece discusses this risk and how Chatham can assist commercial real estate (CRE) borrowers with managing it.
- The rise in interest rates year-to-date has been accompanied by increased short-term volatility in rates, observed in both short-term and long-term rates.
- This volatility is felt by CRE borrowers as increased rate risk between deal commitment and deal closing regardless of loan term structure and choice of fixed vs floating rate.
- In this environment, borrowers need to underwrite a larger spectrum of potential leverage costs.
- Chatham can assist borrowers in quantifying this risk, identifying potential risk mitigants, and sharing the best practices we observe.
The headline narrative for CRE borrowers this year has been rising interest rates and their impact on financing costs for both short-term floating rate and long-term fixed rate debt. Looking past this trend of rising rates, we have also observed another dynamic in the rates market that is impacting transaction economics and that has implications for risk management – interest rate volatility. While the trend of interest rates has been up this year, the path of the increase has not been a steady one. As TD Bank's Priya Misra observed in a research note published June 241, nearly 55% of daily moves in the 2-year and 10-year Treasury rate year-to-date have exceeded a one standard deviation move. She attributes this volatility to the “dueling narratives” of the twin macroeconomic risks we’re facing – inflation and slow growth, the Fed’s trade-off in policy decisions to influence these risks, and a treasury market structure experiencing declining and impaired dealer intermediation. As the graph below (which shows volatility for the yields on 2-year and 10-year Treasuries2) demonstrates, this volatility is impacting both the short end and the long end of the curve and represents, apart from the start of COVID, the most volatile rates market we’ve seen in the last 10 years.
For CRE borrowers, this volatility is not just of academic interest. For an investor acquiring a new asset, it’s common for there to be a 60-90 day window between a deal going under contract and closing. Assuming leverage is being used, this window represents a period of interest rate risk. A fixed-rate borrower may see the benchmark treasury or swap rate over which their loan prices increase while a floating-rate borrower may see the cost of a hedge, like an interest rate cap, increase. In either case, the borrower closes their loan at a higher interest expense than what was assumed when they went under contract. This year, much more so than in years past, this risk is larger – a borrower is much more likely to see a material change in their cost of financing between contract and close. This reduced certainty adds insult to injury in year where lending spreads have also gapped out significantly.
The graph below shows the yield on the 10-year Treasury back to April 1, 2021, and, for each date, the spread between high and low for the yield over the following 60 business days, this range reflecting the volatility in the yield over this period. Looking at this data, consider the example of a borrower closing a financing with fixed-rate debt priced over the 10-year Treasury. Assuming a 60-day commitment to close window, a borrower signing a commitment in April of last year might expect a range of outcomes for the 10-year Treasury at closing of less than 30 bps; in March of this year this range may have exceeded 120 bps.
The story is similar for floating-rate debt. Short-term rates have swung wildly in recent months as market expectations around the extent to which the Fed will need to raise rates to curb inflation have shifted. The graph below shows the forward curve for 1-month Term SOFR from close of business June 15 (immediately after the last Fed meeting) and the curve as of close of business today. The first shows the market pricing in peak Term SOFR rate of 3.77% by March of 2023, while the latter shows a peak SOFR rate 3.50% by March of 2023.
This volatility in short-term rate expectations has driven volatility in interest cap pricing, which have become a significant driver of loan economics this year. Similar to the graph of the 10-year Treasury above, the graph below shows the cost of a 2-year, 3% cap (in basis points on the loan amount) from April 1, 2021 to current as well as the spread between the high and low cost of the same structure over the following 60 days.
If this volatility continues, CRE borrowers will continue to bear the heightened risk of their cost of debt moving materially between commitment and closing. This risk may be two sided: some borrowers will benefit from favorable rate movements. Though, as we’ve observed advising our clients, borrowers are more disappointed in bad news than they are enthusiastic about good news. The bad news harms more than the good news benefits.
What are the implications for borrowers? In this environment, we'd encourage borrowers to consider the following:
- Understand the magnitude of the risk. If you're signing a term sheet for a fixed-rate loan, we can help you understand how volatile the 10-year Treasury and swap rates have been in recent months. If you're closing a floater with a cap requirement, we can tell you how sensitive the cost of that cap is to interest rates over other market factors, and how much it might change over a certain period of time. This awareness alone may not help you mitigate the risk, but it can help avoid unpleasant surprises down the road or, if the identified risk is truly unpalatable, it might change how you view the attractiveness of the transaction.
- Mitigate the risk when possible. For fixed-rate loans, this may make lender rate locks more attractive and may change how you evaluate loan alternatives, or it may lead you to consider other forward hedging strategies. For loans synthetically fixed with swaps, you may consider swapping the loan early, prior to closing. For floating-rate loans with required caps, you may monitor cap costs and consider purchasing them in advance of requirements. This may be impractical for caps on new loan originations but could make more sense for springing cap requirements or caps purchased in conjunctions with loan extensions.
- Be ready to trade. Nothing is more frustrating than seeing a cap or swap you intend to place hit a favorable level but not be able to take advantage of it. Now more than ever, we are seeing borrowers being strategic on the timing of executing hedges. Chatham can work with you to help you be positioned to trade before you’re strictly required to, typically in a way that doesn’t commit you to anything, which makes for a free option worth pursuing.
At Chatham, we help clients think through the range of interest rate environments they should be underwriting and how to manage risk associated with that uncertainty.
Have more questions on leverage mitigation?
Get in touch with one of our advisors today.
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.22-0174
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