By Lerika Joubert, Senior Associate, Taylor Wessing LLP &
Jamie Macdonald, Chatham Financial Europe Ltd
It has become market practice for lenders to include wording in facility agreements that provides that the applicable IBOR (interbank offered rate) shall never be less than zero (a zero floor). But what happens if the transaction includes a corresponding interest rate swap (IRS)? Could the inclusion of a zero floor result in mismatches with rates payable under the swap?
Despite the existence of various contractual solutions to address the effect of negative interest rates in transaction documents—unless this particular issue is addressed properly—there could be a mismatch between the rates payable under the facility agreement and the rates payable under the swap. The possibility of a mismatch should, from a borrower’s point of view, be inconceivable, as the very purpose of an interest rate swap is to hedge the borrower’s interest-rate risks under a variable-rate facility agreement. So it may come as a surprise to many that some borrowers still have issues with mismatches.
How do the LMA and ISDA documents deal with negative interest rates?
The recommended definition for LIBOR as per the Loan Market Association (LMA) English-law-governed syndicated facility agreement includes optional language that if either (i) the applicable screen rate or (ii) (if the screen rate is unavailable) any other base interest rate determined pursuant to the facility agreement, “is less than zero, LIBOR shall be deemed to be zero”. Although optional, this zero-floor language is almost always included in facility agreements.
Negative interest rates are also addressed by the International Swaps and Derivatives Association (ISDA) documents. The default position is that the Negative Interest Rate Method will automatically apply to all swap transactions incorporating the 2006 ISDA Definitions unless the parties specify otherwise (assuming that “compounding” or “flat compounding” are not specified for that swap transaction). Under the Negative Interest Rate Method, the floating-rate payer would normally be required to pay an amount in respect of the floating-rate leg of the interest rate swap transaction (the floating amount); but if, at the relevant date, the amount payable is a negative number as a result of, for example, negative IBOR, then the floating-rate payer is deemed not to owe anything, and the other party is instead required to pay an amount corresponding to the absolute value of the negative floating amount to the floating-rate payer.
Another option available under the ISDA documents is for the parties to specify that the Zero Interest Rate Method is applicable, which relieves the floating-rate payer from the obligation to pay the floating amount on a relevant payment date if the amount payable is negative, but does not (as is the case with the Negative Interest Rate Method described above) require the other party to make a payment of the absolute value of the floating amount to the floating-rate payer.
The counterparties can therefore decide whether they want to apply the Negative Interest Rate Method or the Zero Interest Rate Method, but if no election is made, the Negative Interest Rate Method shall apply.
In practice, however, the Negative Interest Rate Method is used as a default because the interbank market executes swaps for which the Negative Interest Rate Method applies. Therefore, it would be difficult for a bank to provide a swap to a borrower using the Zero Interest Rate Method, whilst its own interbank “hedge” applied the Negative Interest Rate Method.
Why do negative interest rates matter to borrowers and lenders?
From a lender’s point of view, it is quite simple: lenders require a minimum return on their investments, and the purpose of a zero floor in a variable-rate loan agreement is to avoid reduced earnings for lenders by reference to fluctuations in the IBOR rate. If there is no zero floor and the IBOR rate is negative, the borrower will not be paying the lender the IBOR rate at all until such time as the IBOR rate increases above zero, and the overall interest rate payable under the facility agreement will therefore be reduced accordingly.
Lenders would, therefore, argue that a zero floor protects them from (i) the potential erosion of their margins as a result of a negative IBOR, and (ii) what seems like an impossible scenario (under LMA facility agreements) in which a lender could be required to pay a borrower if the overall interest rate itself, under the facility agreement, is negative (as is the case under the Negative Interest Rate Method described above).
A borrower’s main arguments for the exclusion of a zero floor from facility agreements will most likely be centred on the following two points, with the emphasis on the latter:
- First, the idea that if a loan is priced with reference to IBOR, the interest rate under the facility agreement should move with IBOR and fluctuate accordingly—positive or negative; meaning that, if for example, LIBOR goes negative, borrowers ought to have the “benefit” of the interest rate under the facility agreement being reduced accordingly (as is the case under the 2006 ISDA Definitions). However this argument will likely rest on how a lender funds itself.
- Second, the possibility that a zero floor could result in mismatches with rates payable under the corresponding interest rate swap.
Focussing on the possible mismatch, this is an example of a variable-rate loan agreement with a zero floor with a corresponding interest rate swap:
With reference to the above example, a UK corporate borrows money at a floating rate of interest based on the relevant three-month IBOR. In order to protect itself from potentially increased financing costs under the floating-rate borrowing, the UK corporate enters into an interest rate swap with a hedge bank. On the one hand, the swap contract provides that the hedge bank pays a floating rate of three-month IBOR to the UK corporate; on the other hand, the UK corporate pays a fixed swap rate of 2 percent to the hedge bank. The bottom line of the arrangement is that the UK corporate ends up with fixed-rate financing costs of 2 percent.
If the three-month IBOR becomes negative (i.e., -0.25 percent), the UK corporate will have to make a payment to the hedge bank to account for the fact that the referenced floating rate has gone negative. The UK corporate will therefore have to pay the hedge bank 0.25 percent in addition to the fixed-rate payment of 2 percent that it owes under the swap contract. However, this is true only if the Negative Interest Rate Method applies.
Let us assume the margin under the facility agreement, in the above example, is 3 percent plus IBOR and a zero floor has been applied, then if IBOR goes negative (to -0.25 percent), the borrower will continue to pay 3 percent under the facility agreement and will also have to pay 2.25 percent to the hedge bank. If, however, the zero floor was not applied, the borrower would only have had to pay 2.75 percent under the facility agreement and 2.25 percent under the swap contract.
The mismatch, therefore, arises because the borrower has to continue to pay the lender the 3-percent margin, even though under the corresponding swap the floating-rate payer is not required to pay anything to the borrower (i.e., the benefit of IBOR going negative has been passed on to the floating-rate payer), and the borrower has to pay an amount to the floating-rate payer.
The documents, therefore, do not make provision for an automatic mismatch fix across the two financing disciplines, but they do give parties the framework within which to make the necessary changes to avoid a mismatch, the simplest by far from a borrower’s perspective being excluding the optional LMA zero-floor language.
How to avoid or address a mismatch.
As some borrowers do find themselves in the peculiar position of having a mismatch, borrowers should give thought to the following options when negotiating facility agreements with interest rate swaps attached thereto.
- Entirely removing the zero floor from the facility agreement. From a borrower’s point of view, this will be the most desired outcome (assuming the borrower is proposing to hedge its interest-rate risk with a swap), but also the most challenging, especially if the lender deems margin protection to be material in the context of the transaction.
- Not applying the zero floor to that part of the facility that is hedged with swaps. In theory, this is a viable option for borrowers, but it is likely to be too risky for lenders as they would, of course, only have the zero floor “protection” on that part of the facility that is not required to be hedged.
- Buy back the zero floor from the lender (with possible margin reduction). This is less than ideal for borrowers as it would require additional expenditure. Unfortunately some borrowers are left with no option but to incur such additional costs in order to avoid a mismatch—provided, of course, it makes sense from a cost-benefit analysis.
- Hedge with interest-rate caps instead of swaps. A zero floor is not an issue under an interest-rate cap. Provided it makes economic sense for the relevant borrower to hedge with a cap, this would be the simplest solution to the potential mismatch problem.
- Choose fixed-rate loans over floating-rate loans with hedges. As choosing a fixed-rate loan would eliminate the zero-floor issue, this may be something that some borrowers are willing to explore further; that said, this is probably a classical example of the tail wagging the dog as there are various other factors that would determine whether a loan should be a fixed- or floating-rate loan.
- Amend the ISDA documents. If you are hedging with the same lender who is insisting on including a zero floor, then you could argue that if you do not have the benefit of any movements in IBOR (due to the zero floor), the lenders should likewise not have the benefit of the Negative Interest Rate Method under the ISDA; this will, however, be challenging, especially considering that this is the default position and how a lender would hedge itself in the interbank market.
Borrowers will have to consider which option is most suitable to their needs in their particular circumstances, and this will no doubt involve some negotiation with their lenders and hedge banks as it is all about margin protection for lenders.
The inclusion of a zero floor could clearly become a material issue for both borrowers and lenders as negative rates could adversely impact both parties; any union between Mr Zero-Floor and Mr Swap would therefore be challenging, and the terms of any such union will almost certainly depend on the commercial dynamics of the transaction.