Refinancing risks and the potential effect on IRR
Hedging and Capital Markets
Infrastructure | London
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.
- 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).
- 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.
- 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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