The plausibility of negative rates in the U.S. and UK

Market data provided in this post was accurate as of 12:00 PM ET on Friday, May 1, 2020, but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.

Backdrop to a negative rate scenario

When looking to understand the risk of negative interest rates occurring, commercial real estate (CRE) investors should take care to understand the motives behind central bank decisions. From the current levels of “emergency” rates, it would seem that further rate cuts are unlikely—albeit not impossible. For countries that have been in negative rate territory for a few years already (Europe, Sweden, Switzerland, Japan), there are signs emerging that this policy stance has been unsuccessful. The true judgement will not be evident for another few years. But what is clear now is that the impact on the banking and pension sector of the negative rate policy has been extremely detrimental.

Whether the UK and the U.S. will follow these countries with a negative interest rate policy is unknown. Ex-Bank of England Governor, Mark Carney has made official statements that “negative rates are not an option for the UK” with guidance that the BoE’s view is the effective lower bound for rates is close to zero—"positive, but just above zero”. This statement was made pre-COVID-19, but it is worthy to note that the immediate central bank activity which occurred when the extent of the virus impact became known still only took UK rates to 0.10%—positive, but still above zero.

Federal Reserve Chairman Jerome Powell has held a steady stance against negative rates, from resisting President Trump’s taunts for such throughout late last year to stating earlier in the COVID-19 crisis. “We do not see negative policy rates as likely to be an appropriate policy response here in the United States.” This past Wednesday, the Fed held their target funding rates firm with the zero lower bound, despite both 1-month Treasury Bills and an occasional SOFR print dipping below zero, and reputable voices like Narayana Kocherlakota, a former president of the Federal Reserve Bank of Minneapolis, saying the Fed should set interest rates a “quarter percentage point below zero”.

The appearance of the interest rate floor

Whilst negative rates, driven by central bank policy, would appear unlikely in the UK and the U.S., it is expectation/risk that they might occur, which influences behaviour and leads to the appearance of language in loan documentation which contemplates negative rates, and so protects the lender against such an outcome.

This is where the concept of an interest rate floor emerges. This is usually set at a 0% rate, meaning if the relevant benchmark interest rate is negative, it is deemed to be zero for the purposes of the agreement. If the zero floor is not documented, and the benchmark interest rate is negative, the risk to the lender is that the borrower is effectively benefiting from a reduction in the lending margin (if we assume that the interest cost is the sum of the benchmark floating rate and the applicable margin). In loan facilities where no floor appears, the borrower would see the full benefit of negative rates should they occur. However, the question has arisen as to what would happen if the negative rate exceeded the applicable loan margin? In these circumstances, discussions have centred around setting the interest rate floor to the negative of the loan margin (i.e., if the loan margin is 150 bps, then the floor is set at -150 bps). This has the mutual benefit of affording the lender some protection against more extreme negative rates, but would not require the lender to make payment to the borrower for the right to lend the borrower money.*

In the current environment, many loans are being amended to accommodate potential interest repayment deferrals, or to document covenant waivers. Given the increased risk of negative rates in the last few months compared to when the original loan was agreed, there is an opportunity for the lender to insert an interest rate floor where it did not already exist before.

How negative rates and interest rate floors have been "managed" in a hedging strategy

This floor has economic implications that must be considered when looking to mitigate the exposure to floating interest rate risk.

For example, were a CRE borrower to enter into a vanilla interest rate swap, they would be exposed to a rising cost of funds in a negative interest rate environment. This would arise because the borrower would not receive negative LIBOR from the lender that they owe under the swap contract. As such, the LIBOR cashflows do not offset each other in the same way that they do in a positive interest rate environment.

In our experience, the negotiation of the loan documentation tends to take place over a matter of months, with the hedging aspects (and related documentation) not always forming part of these negotiations. This means that there are many situations of a mismatch between the two, with the reference LIBOR rates not being the same for the loan as it is for the hedge. It also reduces the negotiating position of the borrower to deal with the floor at a later date, if the potential hedging strategy has not been a key part of the conversation early enough in the process.

When the loan documentation is in negotiation phase, there are a few different alternatives to deal with the existence of the interest rate floor. The first two are when it is managed at the loan level, and the second two are when it is managed at the hedging level.

• Remove the floor/reduce its impact. This might be acceptable to some lenders, particularly those relationship lenders that intend on holding the loan, and not sell down/syndicate. Failing a full removal of the floor, lenders may alternatively set the floor equal to the negative of the loan margin, thereby ensuring they are never left in a situation where the negative LIBOR cashflow exceeds the loan margin. Alternatively, the lender may agree to carve-out certain suitable hedging instruments from the implications of this clause. For example, for the portion of the debt which is hedged by way of an interest rate swap, the floor will be disapplied. In the U.S., it is uncommon to see loans without a floor of at least 0%, and we have seen a recent trend by lenders to ask for floors at 0.50% to 1.50% (but perhaps waived when a swap is in place).
• Agree to a fixed-rate loan rather than a floating-rate loan. In such circumstances the borrower and lender would have certainty of a known fixed-rate for the duration of the loan. However, when considering such contracts, it is critical to understand how the fixed-rate is being determined as well as the situation regarding calculation of termination values/costs. It is not uncommon for fixed-rate loans to have onerous provisions with significant economic costs if the loan is redeemed (either partially or in full) before its natural maturity.
• In negative interest rate environments where the floor applies, there has tended to be a preference toward hedging by way of interest rate caps. Such interest rate instruments provide a known worst-case cost of funds whilst maintaining the ability to benefit for as long as rates remain low. In such circumstances, the borrower has created an interest rate collar, with LIBOR floored at 0.00% owing to the 0.00% floor in the facility agreement and then capped at the strike chosen by the borrower via the hedging strategy. Caps are considered “cheap” and the chart below indicates the premiums on a 1% strike cap.

• Given the collapse in rates, many borrowers are actually looking toward swaps as a better value hedging instrument. If an interest rate swap is deemed the optimal hedging instrument, the management of the interest rate floor is slightly more complex. To create a perfect match with the loan documentation, the equivalent interest rate floor has to be purchased as part of the hedge (if you think of existence of the floor in the loan document as being a “sold option” by the borrower, then to negate its impact the borrower needs to “buy” it back). The chart below shows the cost of interest rate floors as a percent of the notional being hedged. In most circumstances, this floor premium is embedded into the swap rate, therefore taking the fixed-rate of interest up by a certain number of basis points and the floor is paid for on a running basis. The other benefit of this strategy is that it does place a ceiling on the extent of any negative mark-to-market (and so termination cost) if the hedging needed to be terminated and interest rates had fallen further.

Summary

While the prospect of negative interest rates in the UK and the U.S. might seem unlikely, it is increasingly being contemplated within loan documentation, typically by inserting interest rate floors within the definition of LIBOR.

There are a few different ways to manage/mitigate the interest rate floor, but early discussions with the lender during the loan facility negotiations leads to a broader range of solutions, and ultimately better outcomes for the borrower.

We’ll continue to provide updates as we see market conditions evolve and implications for our CRE clients change. In the meantime please feel free to reach out to your Chatham representative if you'd like to further discuss any of the themes above.

*This is a purely hypothetical point as the interest obligations under most facility agreements are expressed solely as an obligation on the borrower to pay.