Interest Rate Hedging – a summary introduction for borrowers and current market trends

The era of zero interest rate policies is over. We had grown accustomed to living in a low-interest rate economy. Since the end of 2021, base interest rates have been steadily increased to stabilise and address high inflation.

The risk of rising and unstable interest rates is now a significant concern for borrowers of floating rate loans, much more so than in the decade up to the end of 2021 when rising interest rates seemed unlikely and hedging interest rate debt felt like an administrative formality for many. To address adverse interest rate risk, it is usual for borrowers to hedge interest rates under an interest rate swap or cap product.

Interest rate swaps

Product: An interest rate swap is an exchange of cash flows. The borrower will pay a fixed amount to a bank (usually a lending bank), and that bank will pay a floating amount to the borrower. The floating rate is calculated by reference to the interest rate of the loan (such as SONIA). Usually at the start of the interest rate swap, the fixed amount payments will exceed the floating amount payments. However, if interest rates rise, the floating rate that the bank must pay to the borrower may exceed the fixed amount that the borrower must pay. Essentially by fixing payments under an interest rate swap the borrower has commercial comfort as to the cost of its borrowing over the term of the loan. No matter how high interest rates rise, the borrower will only need to pay the pre-agreed fixed rate under the swap.

Swap contracts: As swaps involve an ongoing credit risk against a borrower, swaps are documented under an ISDA Master Agreement, Schedule and Confirmation. Template ISDA terms should be adapted to reflect that the swaps are part of a broader financing arrangement with consistent terms. Such terms are often closely negotiated. It is commercially and legally important to a borrower that it is not overhedged during the term of a loan, its hedging terminates on repayment of all drawn debt and the hedging bank has highly restricted rights to terminate the hedge before the expiry of the term of the loan.

Interest rate caps

Product: An interest rate cap puts a ceiling on a borrower’s interest rate. The premium for a cap is commonly paid upfront, though staggered payments are sometimes agreed. Unlike a swap, a fully paid cap doesn’t have a prepayment penalty. No prepayment cost can be attractive to borrowers that are looking to refinance their debt, as there are no break costs with fully paid caps. The cost of terminating a swap can be high and could affect a decision to refinance. A borrower might also seek to roll over a cap to hedge interest rate risk on replacement (refinanced) debt as there should be no requirement for the cap to terminate on a refinancing.

Cap contracts: Fully paid caps are usually documented under a long-form ISDA Confirmation. As the hedge provider (usually a lending bank) doesn’t have any credit risk to the borrower, the hedge provider’s right to terminate a fully paid cap should be minimized. Template ISDA terms are usually heavily amended to achieve this. Partially paid caps where there are staggered premium payments often have similar legal terms to swap contracts.

Link to credit agreements and intercreditors

The contractual implications of whether a swap, a partially paid cap or a fully paid cap will be entered into has a wide ranging impact on the terms of the linked facility agreement and any intercreditor agreement.

If the hedging product will be a swap or a partially paid cap, because of the ongoing credit risk against the borrower in its capacity as the end-user of the hedge, a breach of the terms that swap will be an event of default under the credit agreement.

If the hedging product will be a fully paid cap, a hedging bank will have no credit risk on the borrower once it has paid the premium. Therefore the terms of the cap shouldn’t be capable of cross-defaulting the linked credit agreement. The only obligation related to hedging in the facility agreement should be that the hedging covenant is complied with.

With respect to any intercreditor arrangement, a hedging bank that is providing a swap will be a creditor of the borrower and may share the security/ guarantee package with other creditors, such as debt providers. This means there will be detailed legal terms that will influence the behaviour and rights of a hedging bank, and to some extent the behaviour and rights of the borrower with respect to the hedging agreements.

Current trends

• Both banks and borrowers might require hedging to be entered into at drawdown, rather than as a condition subsequent (such as within 90 days of drawdown). This would lock a borrower’s borrowing costs at the outset of a financing arrangement.
• A greater portion of the drawn debt is being hedged, often up to the full amount of the borrowing.
• In addition to caps and swaps, borrowers are starting to consider different types of interest rate hedging products to lock in interest rate costs as early as possible (such as a forward starting interest rate swap or a deal contingent swap, each of which would be entered into prior to drawdown).
• If for whatever reason, the SONIA base rate for a loan is unavailable and a market disruption event occurs, the debt’s interest rate fallback and the hedge’s interest rate fallback should be aligned. As the loan agreement and hedging agreement will be documented under different legal agreements (albeit from the borrower’s perspective, it is the same commercial arrangement) and negotiated with different bank departments, it is common that the SONIA market disruption fallbacks are different under each agreement thus potentially leading to a mismatch. The risks from a mismatch should be carefully managed and understood.

We would be pleased to discuss if you have any questions.

Jeremy Ladyman is a partner in the Banking and Finance team at Irwin Mitchell.