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Negative defeasance penalties return for the first time since 2006


Chatham Financial has executed several defeasance transactions with negative penalties this fall. Negative defeasance penalties occur when replacement Treasury yields exceed the loan’s coupon. This scenario allows commercial real estate (CRE) owners to exit their CMBS (Commercial Mortgage Backed Securities) loans at a discount to the outstanding principal balance. Current market expectations are that rates will continue to rise in the short-term, making potential negative defeasance penalties an important factor in prepayment and defeasance decisions. For borrowers with loan coupons that are lower than prevailing U.S. Treasury rates, negative defeasance penalties may be possible.

Frequently asked questions:

  1. Does a negative defeasance penalty mean that I get paid?
    • All defeasance transactions require that a bundle of securities be purchased to cover the remaining payments due under the loan. With a negative defeasance penalty, the cost to purchase those securities is lower than the remaining loan balance. This allows the borrower to exit their loan at a discount to par.
  2. How does a negative defeasance penalty affect residual value?
    • A negative defeasance penalty is typically associated with a rising interest rate environment. As rates rise, float value increases while prepayment value decreases. Learn more about residual value.

Defeasance is the process through which a borrower is released from the financial obligations of its debt. The borrower purchases a portfolio of government bonds, typically Treasury securities, as replacement collateral to secure the debt and to generate the cash flows required to meet the scheduled payments of principal and interest remaining on the loan. The cost of defeasance is comprised of two parts:

  1. Securities cost: the cost of that portfolio of bonds that are sufficient to provide for the remaining loan payments
  2. Transaction fees to several third parties

The difference between the securities cost and the outstanding principal balance of the loan is referred to as the defeasance penalty.

If the yield on the replacement portfolio of bonds is less than the loan coupon (which most borrowers are accustomed to), defeasance becomes a punitive way to exit debt since the cost to purchase the portfolio of bonds will exceed the outstanding principal balance. As yields increase, the price of the replacement portfolio of securities falls, lessening the defeasance penalty to exit the debt. Once yields rise above the loan coupon, the cost of the portfolio of securities can be less than the outstanding principal balance – resulting in a negative defeasance penalty.

Negative defeasance penalties have been a hypothetical topic in recent years. Today, they are becoming increasingly relevant due to the rising interest rate environment. This type of environment is the reason that Chatham advises borrowers to include both a defeasance and yield maintenance option in their loans when possible. While yield maintenance is usually a less expensive and time-consuming process when interest rates are below the loan coupon, it also is typically associated with a minimum penalty amount. Defeasance does not have a minimum penalty and allows borrowers to fully capture the savings impact of rising rates when exiting a loan.

On September 1, 2022, Chatham executed its first defeasance with a negative penalty since 2006. Chatham had been providing ongoing analysis for the client starting at the beginning of 2022 as they evaluated defeasance costs in connection with an acquisition. As rates continued to rise and estimated penalties drew closer to zero, the concept of negative defeasance penalties was introduced as a real possibility. The chart below highlights the effect of the rate increase on the 7-year U.S. Treasury (the tenor of Treasury most closely aligned with this loan’s maturity date) on the client’s defeasance penalty from the beginning of 2022 through defeasance closing on September 1, 2022.

At defeasance closing, the yield on the U.S. Treasury was higher than the loan coupon, and the borrower was able to exit their loan at a ~$553,000 discount to the outstanding principal balance.

If your loan coupon is lower than the Treasury rate that is closest to your loan’s maturity date, and you are contemplating a sale or a refinance, contact us to determine whether you can defease your loan at a discount to par.

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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

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.