“Springing” interest rate cap requirements for European borrowers
“Springing” interest rate caps are a type of loan requirement that requires a borrower to purchase an interest rate cap post loan closing if (and only if) the floating reference rate (EURIBOR, SONIA) or a fixed reference rate (swap rate) crosses a certain threshold (often called the “trigger”). This structure permits the borrower to defer (and possibly avoid) the premium cost of an interest rate cap at the risk of a higher future cost if rates rise sooner and more than expected. With rising interest rates and cap premiums, such provisions are being triggered in existing loans. This piece provides an overview of how a borrower should weigh the potential risks and benefits of such loan provisions.
- A springing interest rate cap is a loan requirement which requires a borrower to purchase a cap if the index rate for the loan crosses a predetermined threshold.
- Springing caps allow a borrower to avoid the cap’s upfront cost at the time of loan closing. Over the life of the loan, the borrower may avoid the cost entirely if rates remain low but will pay more if rates rise sufficiently.
- With short-term rates rising, we expect these provisions in many loans to be triggered, requiring borrowers to purchase an interest rate cap.
- Borrowers evaluating such a provision in a new loan origination should consider the current forward curve, their expectations for paying off/refinancing the underlying debt, and their tolerance for risk and uncertainty in interest costs.
- Chatham can assist borrowers in reviewing their existing loan portfolios for the presence of springing cap requirements and whether such caps should be purchased in advance of being triggered.
The immediate benefit of such a structure is that the borrower avoids the upfront cost of the cap. Over the loan’s term, they may avoid the cost entirely if rates don’t cross the threshold triggering the purchase, or they may find that the cost of the cap is less than if they had purchased it upfront if rates do cross this threshold but no faster than originally expected at the time of the loan close. Conversely, if rates rise more quickly and/or more significantly, the cap requirement may be triggered and cost more than if the borrower had just purchased the cap at closing. This approach will often appeal to borrowers that hope to sell/refinance the underlying asset in advance of loan maturity or to borrowers that are willing to take the view that rates will be lower for longer than the forward curve prevailing at the time of the loan close.
With the recent rate hikes from the Bank of England (BoE) and expectations for additional hikes both from the BoE and European Central Bank (ECB), this structure has come up frequently in our client conversations, primarily in two contexts. First, clients want to assess their existing loan portfolios to understand if they have any loans with these provisions and, if so, what their obligations are. The challenge for borrowers in the current market is the fact that the compounded SONIA rate is substantially lower than forward rates (the latter being a retrospective rate and the former already reflecting interest rate hike expectations). This has led to conversations where the trigger rate is not quite at the threshold level but the cost to buy the interest rate cap at the pre-defined strike rate is prohibitively expensive; and so, borrowers are looking for an alternative solution to avoid this cost.
The second context has been situations in which clients are looking at new floating-rate loan originations with hedge requirements. Given the substantial increase in the cost of interest rate caps since the beginning of the year, many borrowers and lenders have been exploring approaches for mitigating these costs. Springing caps have been one of several approaches we’ve seen employed in new loans to reduce upfront hedging costs. However, this could be risky, particularly in the event that rates end up even higher than what the market has currently priced in.
In both of these contexts, a common theme in conversations has been the timing for purchasing springing caps – should a borrower purchase a cap now to “get ahead” of a purchase requirement that may be triggered in the future (thus locking in a known cost today), wait to purchase the cap only if and when it’s required, or defer and re-evaluate the purchase at some future date? These are always tough questions to answer. At their root, these are questions of where rates will go and what cap prices in the future will be relative to cap prices today, neither of which are easily predicted. Understanding some key concepts and considerations can give borrowers a better framework for considering springing caps:
Forward curve: A starting point for evaluating whether a borrower should “get ahead” of a springing cap requirement should be the current forward curve for EURIBOR/SONIA. While the forward curve has historically been a poor predictor of rates, there’s some argument to be made that the front of the curve may be more predictive given how much the market has already priced in (over and above what has been announced). As the time of writing, the current forward curve shows SONIA hitting 3.26% by September 2023 and EURIBOR at 2.32% by January 2024. A borrower with a “springing cap” triggered when SONIA hits 2.00% might be more inclined to purchase the required cap today, understanding that the market is projecting it may be required in a few months anyway. Conversely, a borrower with a cap triggered when SONIA hits 4.00% may be more inclined to wait and hope the trigger never materializes.
Borrower view of forward curve: Generally, so long as rates follow or undershoot the path implied by the forward curve, any deferral of a cap purchase will make sense in hindsight. Similarly, a deferral may look like a bad idea in hindsight if actual rates exceed the path projected by the forward curve. With this in mind, a borrower that wants to take the view that rates are more likely to exceed the forward curve would be more likely to purchase a springing cap early and, conversely, a borrower more inclined to take the “under” on the forward curve should be more inclined to wait.
Interest rate volatility: It’s intuitive that the term and strike rate of a cap, along with the market’s implied expectations for future rates, can impact cap pricing. A less intuitive, but often just as significant, factor of pricing is interest rate volatility. This measure reflects the market-implied probability and the extent to which actual rates may deviate from the forward curve in a way that drives larger than anticipated payouts from the cap provider to the borrower. While it’s impossible to predict how volatility will change over time, the impact of volatility on a particular cap structure can be quantified. In this way, a borrower can gain an understanding of the magnitude of pricing risk that this factor introduces to a borrower considering deferring a cap purchase to meet a springing cap requirement in a loan.
Sensitivity of cap pricing: Cap pricing is sensitive to a variety of factors, including movements in interest rates, interest rate volatility, and the cap’s term. While we can’t predict how pricing will evolve over time, we can put numbers on how sensitive a cap’s pricing is to these different factors, and which factor plays a more pronounced role on a relative basis. A borrower that is informed of these numbers will have better intuition on how the cap pricing might change over time and will be able to better evaluate the potential benefits of purchasing a cap now vs. waiting until later.
Asset strategy: As with all hedging decisions, the approach a borrower takes to a springing cap should be informed by the business plan for the underlying asset. A shorter hold period or early refinance for the underlying asset should, all else equal, make a borrower more inclined to defer a springing cap purchase as long as possible, and vice versa if there is a longer anticipated hold period or window of refinance.
Lender flexibility: Irrespective of the loan language regarding a springing cap, a lender may be willing to waive or modify these requirements. We’ve seen several instances where our clients have been able to negotiate adjustments to these provisions with their lenders. It's worth clarifying, though, that lenders tend to view these situations on a case-by-case basis, factoring in heavily the underlying asset performance and their relationship with the sponsor.
Sensitivity analysis: As mentioned above, trying to accurately predict future cap costs is a fruitless exercise. We do think sensitivity analysis on what a cap cost might be in the future based on different rate environments can be a helpful exercise for a borrower to establish a range of outcomes and so better quantify the risk of deferring a cap purchase until later.
Please reach out to us if you would like us to review your portfolio of loans to identify any springing hedge requirements. Also, reach out if you would like us to help you think through how to handle a specific springing cap situation, whether that is to better understand when that requirement may be triggered or for an evaluation on purchasing the cap now vs. waiting until later.
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Contact Chatham to review your loan portfolio for springing cap requirements.
This material has been created by Chatham Financial Europe, Ltd. and is intended for a non-U.S. audience. Chatham Financial Europe, Ltd. is authorised and regulated by the Financial Conduct Authority of the United Kingdom with reference number 197251.
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