In this video, Ruth Hardie, senior director of client services, provides an overview of what you can expect from interest rate swaps given the current large drop in rates.
As of March 31, 2020, short term rates hovered below 0.5%. Long term rates have also remained below 1%. This low interest rate environment has created some big changes for derivatives, hedge accounting, hedge effectiveness and trading.
How has the decrease in rates impacted derivatives?
For pay fixed, receive floating swaps, you can expect much larger liabilities. We are continuing to see blend and extends where the fixed rate paid is lower and the term is increased.
For pay floating, receive fixed swaps, you can expect much larger assets. Because of this, many companies are monetizing assets to lock in gains.
You can expect much smaller assets with interest rate caps. For floors, if you’re holding the floor, you can expect much larger assets.
- Cross-Currency Swaps
Many of these are in-the-money, depending on the currency and direction.
How has the decrease in rates impacted hedge accounting?
- Cash flow hedges
With a swap, you have locked in a rate that is above current market rates. The hedge is still working in that your interest expense is known.
With a cap you have limited your exposure and you are able to get the full benefit (less premium paid) of the current low rate environment
- Fair value hedges
With a swap hedging fixed rate debt, you are taking full advantage of the low rate environment.
How has the decrease in rates impacted hedge effectiveness?
For floored debt hedged with a swap (without a floor), regression statistics will start to dip if the current environment persists. It’s still unclear how quickly it will happen, but you can expect a regression data point that is more misaligned than previous data points, impacting hedge effectiveness.
How has the decrease in rates impacted trading?
A lot of companies are hedging future fixed rate debt. You can get amazingly low rates from T-Locks or forward starting swaps, for example. In fact, you can lock in 10-year rates at quite a bit less than 1%.
When it comes to debt refinancing, it’s not necessarily a great time to be doing this. Credit spreads have seemed to widen a bit (a lot in some cases). We’re also seeing that as rates have plummeted, banks are asking for a higher floor instead of 0% floors.
Floors have become more expensive to trade. And the execution spread (the spread that counter parties charge above mid-market) has widened across the board.
What about FX rate changes?
- Cross currency swaps
Some of the recent foreign exchange rate changes have been significant. For example, the British Pound went down 2.75% in March compared to February while the Canadian Dollar went up 5.10%. Depending on where you are on the cross-currency scale, whether you’re paying the currency or you’re receiving it, you can expect some big changes.
If you have a fixed-for-fixed swap, the changes are going to be from the exchange rate if you’re in one of the currencies that had a large exchange rate change.
If you have a final payment at the end of the swap (most do), the final payment will be discounted less because interest rates have gone down (in the U.S.).
We are continuing to keep a pulse on the interest rate environment and monitoring changes and impacts as we see them. This is an unprecedented time where currencies and rates are behaving in ways we haven’t seen before. If you have any questions about how your programs may be changing, please contact us.