Rising interest rates present challenges for both investors and corporates. However, there are a variety of cost-effective solutions available, according to Matthew Reader, Head of Fixed Income Structured Products and Jonathan Rogers, Head of Rates & Hybrid Structuring, EMEA.
After many years of historically low rates, change is afoot in both the US and Europe. Swap curves indicate sharply higher expectations for USD and EUR as do Euribor and USD Libor forward curves. In the US, the Federal Reserve has already hiked rates and made it clear that further increases will follow this year; the European Central Bank has scaled back its asset purchasing programme given the pick-up in eurozone inflation.
The implications of a rising rate environment after such a prolonged period of low rates are profound. For asset-side clients such as insurance companies and pension funds, the hunt for yield continues for the time being. Liability-side clients, such as corporates, must decide whether to lock in current historically low rates (and at what cost) or wait and see how the market develops. Both groups should be considering cost effective protection to mitigate the risks they may face.
Asset managers and insurance companies have substantial fixed rate bond portfolios, which could be heavily impacted by rising rates. An additional challenge is that many insurers continue to have a mismatch between assets and liabilities – with a surfeit of short-dated assets and predominantly long-dated liabilities – which creates problems, especially given the stringent requirements of Solvency II.
The obvious solution for such investors is to buy long-dated assets. Given high capital charges on many types of assets, investors’ focus is primarily on sovereign or quasi-sovereign issuers, such as municipalities, regional governments, or government-owned policy banks. However, these are in relatively short supply and new long-dated paper from such issuers has been warmly received. During 2016, both Ireland and Belgium sold 100-year private placements (both sales were managed by Nomura and another bank) capitalising on investor demand for very long-dated paper; Ireland’s note yielded 2.35% while Belgium’s bond offered 2.3%.
There has also been increased interest in structured notes, such as the 50-year issue sold by the Belgian Region of Walloon and a 60-year note for Bank Nederlandse Gemeenten, a Dutch local government and public sector funding agency (Nomura managed both transactions).
Structured notes can be tailored to the specific needs of investors. For example, the Region of Walloon issue references the 20-year swap rate rather than the more commonly used Libor rate because many insurance companies have liabilities linked to the swap. While few sovereigns have issued structured notes – Italy is a notable exception – a number of quasi-sovereigns such as development banks and regional governments have done so in order to broaden their investor base and access slightly cheaper funds.
Another alternative for investors seeking yield is repackaged bonds. Repackaging uses an existing bond that may have some characteristics that make it unattractive to some investors (such as inflation linkage) but others (such as the return) that are attractive. The bond, which retains its original credit risk, is purchased by a special purpose vehicle, which issues a note with new characteristics that investors want. For example, a government inflation-linked bond might be repackaged as a fixed rate note or constant maturity swap (CMS) with the change in the coupon structure achieved via a swap with the bank repackaging the bond. Nomura has worked with other leading banks to standardise repackaging documentation, helping to make the market more transparent and convenient for investors.
A further alternative for investors seeking to broaden their investment options as rates begin to rise is quantitative investment strategy products. These dynamic products are available in a swap or fund format and are structured as standard fixed income instruments but can reference rates, FX, commodities and other asset classes, giving investors greater diversification. Depending on the product, reallocation between asset classes can occur automatically according to market dynamics. For example if swaps rise, the product may automatically rebalance to go short swaps. Although not suitable for every investor, many asset managers’ mandates are being amended to give them greater flexibility to hold such products.
There is also growing demand for hybrid products which combine multiple exposures. For example, a CMS or range accrual might be combined with exposure to sovereign risk in order to increase return. Such products have been available for some time but have become increasingly popular given low rates and yields. Typically an investor will take on risk that they are already comfortable with, such as their own sovereign risk or local currency risk, and combine it with a view on rates, for example. By taking on additional risk that the market ascribes value to – but the investor is comfortable with – returns can be boosted compared to a standard range accrual on short-term rates for example. Hybrids can be as complex as the client requires, referencing multiple markets and trigger levels, for example.
For corporates facing potentially higher interest rates when they borrow, the current environment is attractive: a floating rate bond is likely to achieve costs close to historical lows. However, forthcoming rises in interest rates could significantly increase borrowing costs.
The simplest form of protection for such borrowers is a vanilla interest rate cap. As the price of such caps is largely determined by volatility – which has been depressed by investors entering into trades to sell volatility in order to generate returns in the low rate environment – caps are currently relatively attractively priced. If, however, borrowers don’t want to spend money on option premia, the fraction of a basis point that a vanilla swap costs is extremely competitive when compared to the potential for borrowing costs to rise by hundreds of basis points should rates begin to increase rapidly.
However, a cap has an upfront or running cost regardless of any future market moves, which some corporates may be reluctant to pay given uncertainty over the timing of interest rate rises.
Fortunately, there are a number of solutions available to help corporate treasurers mitigate such risks cost effectively. For example, with a contingent premium cap the buyer is not required to pay upfront but only after a trigger level – a set strike price for three-month Euribor, for example – is reached. If rates remain below the cap strike during the life of the transaction there are no costs. But if rates rise, the corporate benefits from cap protection.
Another alternative is a periodic knock-out swap, which have been popular among European and Middle Eastern banks in recent months as their corporate clients have sought to hedge their USD Libor-linked borrowing. In this structure, the swap is made cheaper by the client selling some of the upside risk: the client pays a fixed rate and receives three-month Euribor, for example, provided it remains below the knock-out strike price.
The market environment has been challenging for investors searching for yield for some years. Now they potentially face a new set of challenges as rates begin to rise. Equally, corporates concerned about the speed and timing of rate rises and the implications for their borrowing strategies must contend with markets that have already priced in a series of rate rises by the Federal Reserve during 2017. Both investors and corporates must make an informed decision about how rates will change and whether they need to mitigate risks: should they decide to take action, there are now a wide range of cost-effective strategies available to help them achieve their objectives.
Head of Fixed Income Structured Products
Head of Rates & Hybrid Structuring, EMEA