U.S. real estate market update—February 26, 2021
Summary
Markets are pricing in the first 25 basis points of Fed rate hikes to occur mid-2023 versus early-2024. Benchmark Treasury yields hit their highest points since the start of the COVID-19 pandemic and the levels strained liquidity in U.S. interest rate markets.
Key takeaways
- The market’s outlook on a hawkish Fed leaves short-tenor interest rate hedge (two years and less) costs up with an even sharper increase on longer-tenor interest hedges (reflected either in the upfront interest rate cap premium or swap coupon).
- Given the majority of lender-required interest rate caps tend to require a 3-year initial maturity, commercial real estate borrowers will face a higher premium on similar strikes as compared to the past few months.
- For those with institutional hedging programs or looking to hedge future financing risk, forward carry costs have also risen sharply since the beginning of the year.
What’s driving the change?
A steeper forward curve beginning in 2023 is driving the increase on cap premiums and swap rates for trades beyond two years. The market is pricing in expectations around rate hikes happening sooner than previously forecasted. The sudden shift in market expectations in the short-end of the curve also drove up the cost of option volatility (one of the technical factors related to a dealer’s ability to offset risk) which has, equally if not more so, driven up the cost of caps.
Figure 1 shows how the difference between the February 25, 2021, LIBOR forward curve has widened from the LIBOR forward curve from the start of the month. While the trend does not guarantee that forecasted rates will continue to climb, it does illustrate how quickly expectations of the levels of interest rates in the future can change.
Figure 1: change between the February 25th, 2021, LIBOR forward curve compared to the start of the month and start of the year
LIBOR settings haven’t really moved day-to-day, but…
LIBOR spot settings have stayed relatively consistent over the time period and haven’t reflected the volatility shown in the longer-dated Eurodollar futures market. Both caps and swaps have become more expensive (reflected in the premium or coupon) beyond the two-year time horizon due to the movement in the underlying rates. The movements are better reflected in the monthly money swap rates (which reflects the rate at which you can swap 1-month LIBOR to fixed). More specifically, the pricing dynamics are better reflected by the change in the 2-year swap rate (or rather the lack of change as the index has stayed relatively flat year-to-date), and the shift in the 3-year, 5-year, and 7-year swaps (all up, with the 5-year up about 30 bps and 7-year up around 40 bps). Figure 2 highlights the divergence in movement between the 2-year swap rate and the longer tenor swap rates.
Figure 2: movement in the 2-, 3-, 5-, and 7-year monthly money swap rates year-to-date
Similarly, the cost of purchasing interest rate caps across all tenors has gone up, with longer tenors (3+ years) rising faster than shorter tenor trades. We’ve seen the rate movement impact dealers to varying degrees, but the directionality of costs has been consistent across the market on both LIBOR and SOFR caps. Anecdotally, we have seen 50%+ increases in premiums on 2-year caps and near doubling on premiums for 3-year caps in certain structures.
Additionally, the implicit costs of forward hedging to mitigate future rate risk have trended up since the year began. Figure 3 highlights the increase in forward carry since the year began. Forward carry represents the difference between the spot-starting rate and the future-starting rate.
Figure 3: 1-year forward carry on the 10-year semi-bond swap rate
Regardless of whether the shift in interest rate expectations indicates a longer upward trend or is a temporary anomaly, it makes sense to approach interest rate risk management proactively especially as market expectations can and will change both rapidly and dramatically.
As questions around the market dynamics come up, please reach out to your Chatham representative to discuss ways to effectively hedge your interest rate risk.
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Disclaimers
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.
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