Updated: Sep 24, 2024
Topics: Pre-hedging/ Interest rate risk/ Project finance
In both the United States and Europe, 2019 and much of 2020 were two years of sharp declines in long-term rates. For companies that regularly use long-term borrowing, the historically low level of long-term rates has led to the increasing use of pre-hedging strategies.
On the contrary, in recent months we have witnessed a rapid rise in long-term rates. Borrowers who have pre-hedged rates welcome this, and other borrowers are now questioning the relevance of these pre-hedging strategies.
In which case are pre-hedging strategies appropriate? ]—the recent rate hike reflect a change of regime or a simple readjustment of long-term rates at the end of the pandemic? What are the parameters for an interest rate pre-hedging strategy?
What does the recent rise in long-term rates reflect?
As shown in the graph below, long-term rates in the US and Europe have increased over the last 8 months by 113 bp and 26 bp, respectively. This rapid increase comes at a time when neither the Federal Reserve nor the European Central Bank are planning to raise their intervention rates in the next 2 years.
Rates remain historically very low, particularly for the euro
At most, the US Federal Reserve is suggesting a 2024 horizon for a possible first-rate hike if conditions are met on that date; as for the ECB, there is no foreseeable rate hike on the horizon at this stage.
The ECB even intends to increase the volume of its asset repurchases in order to counter any rise in market rates and does not rule out a further cut in key rates. But short-term rates and long-term rates can be very disconnected since with the same level of short-term rates, we have experienced spreads of more than 1% on long-term rates. In Europe, we are also still in an environment where the rate curve – and therefore the gap between long-term and short-term rates – is not very steep compared to the situation that prevailed in 2013, for example.
Long-term and short-term rates can be very disconnected
As shown in the graph below, with the current short-term rates and the slope of 2013, the 10-year rate would be 76 bp higher than the current level.
This rate hike, triggered in the United States and then partially transmitted to Europe, stems from the fear of the resurgence of inflation which is making headlines in the press and worrying Wall Street.
Inflation, long desired in vain by central bankers, would be fuelled by the end of the health crisis and the American stimulus plan of 1,900 billion dollars (9% of GDP) which could lead to at least temporary overheating of the American economy.
The markets fear that if the weapon of a short-term rate hike is belatedly used by central banks to counter inflation, inflation will run wild. Such a runaway could then require much more energetic action by the Federal Reserve and a forced acceleration of the key rate hike schedule.
Hence the weaker investor appetite for fixed-rate bonds, especially since risky assets such as equities are upbeat at the start of the year.
At the same time, the sharply rising budget deficits of the main states and the lengthening of the debt desired by these issuers in order to take advantage of very low long-term rates so as to finance cheaply the booming public deficits weigh on the bond markets and fuel the rise in long-term rates.
So, is the rapid rise in long-term rates an exaggerated movement which calls for some correction, at least in Europe where the outlook for overheating seems more distant–or is it the start of a more significant movement with, for example, a return of long-term interest rates on the levels seen at the end of 2019 or even beyond?
Obviously, it is impossible to say, and opinions are as always very divided.
Should we pre-hedge future loans?
When financing a project for the long term, say 10 years of average life, a spread of half a percent in the rate is worth almost 5% of the debt base to shareholders. This is a very large amount which can jeopardize the overall economy of a project.
Pre-hedging the debt rate can therefore bring a lot of comfort to sponsors, providing that they choose the right(s) product(s) based on the probability of cancelation or delay of the project, that they properly sized them, that they control them well, and that the transition between pre-hedging and the hedge is properly managed.
Finally, while some sponsors will regret not having pre-hedged earlier and may feel that it is already too late, it should be borne in mind that in March 2021 neither the slope of the yield curve nor the levels of volatility are still particularly high, given their historical levels.
Moreover, even if long-term rates had already increased significantly, pre-hedging would not lose all its meaning. In fact, pre-hedging makes it possible to protect against a rise in interest rates between the moment the project was designed, structured, committed, and the moment of financial closing. Even when rates are at a higher absolute level, committed projects carry the risk of a rate hike.
Sizing the pre-hedge
When a borrower wishes to pre-hedge one or more future loans, the question arises of the scope of the pre-hedging. Should we, for example, reserve pre-hedging for a single well-identified project or can we set up a “macro” pre-hedge encompassing several future projects over a relatively long period?
On this question, the answer is not unequivocal and depends a lot on the context. But two things are particularly important in the analysis:
Are the projects and loans considered highly probable? If not, the potential cost of pre-hedging can generate a deadweight loss in the event that the projects do not materialize.
Can the competitiveness of projects be reduced by pre-hedging? For example, is it possible that competitors who have not pre-hedged the rates could, in the event of a sharp drop in rates, offer cheaper and more competitive projects, which would in fact make projects and loans less likely, bringing us back to the first point...
Therefore, in project financing, pre-hedging relates more to highly probable and committed projects. Or the highly probable part of the projects undertaken...
2. Pooling pre-hedging
When a company finances multiple projects, it is possible to set up macro-hedges, pooling the benefits and uncertainties between the different projects.
These macro-hedging strategies have particular challenges, especially when transitioning from pre-hedging to hedging.
3. Pre-hedging instruments
There are three main families of pre-hedging instruments, all three widely used in the context of project financing.
Firm pre-hedging
This is typically a forward starting swap. In the case of project finance, however, the question of guarantees given to hedging banks arises, since at the pre-hedging stage, the project security package is generally not available yet. It is therefore necessary to substitute for the project security package, until the financial closing, another form of guarantee which can be a First Demand Guarantee (FDG) from a sponsor or a third party in favour of the hedging bank or collateral in cash for example.
The structuring and sizing of the guarantee are to be defined and negotiated on a case-by-case basis, based on the volatility of the underlying index. This pre-hedging solution requires the ability to provide these guarantees.
Optional pre-hedging
This is typically the purchase of a swap option (called a swaption) between the pre-hedging date and the anticipated financial closing date of the project with a temporal safety buffer estimated to absorb any project delays. One of the problems often lies in the ability to finance the premium for this option, but this solution has the advantage of allowing the project to continue to benefit from any significant drop in rates while being protected against a rise in rates–by paying the option premium, of course.
The costs of optional protections have increased but remain relatively low historically
Contingent pre-hedging
This is a pre-hedge (swap or option) which is deactivated if the project does not close. It avoids the case where it would be necessary to unwind a hedge in the event of non-realization of the project at a potentially high cost. For projects that cannot pay an option premium or put up collateral during the pre-hedging period, contingent hedges are one of the few alternatives available.
Contingent hedging has a cost called the contingency margin which is the counterpart to the risk of non-completion of the project assumed by the bank. Contingent hedges are not offered by all hedging banks and remain reserved for projects whose completion is highly probable.
4. From pre-hedging to hedging
At the time of the financial closing, depending on the value of the pre-hedging instruments, two solutions are possible:
Integration of the value of the pre-hedging instrument in the rate of the final hedging instrument
Termination of the pre-hedging instrument against payment or receipt of the Mark to Market
Depending on the location of the pre-hedging, i.e. depending on whether it is hosted in the borrowing company or in a parent company, the question of the transfer of pre-hedging instruments or their value must also be considered. This raises questions of accounting impact, impact on project ratios, cost of financing the mark to market, etc..
Conclusion
The virtue of pre-hedges is that they reduce the risk on a project's profitability and can avoid many disappointments for shareholders. Giving up earning potential to protect unfavourable cases is a good risk management practice which takes on its full meaning when the risk materializes and calls into question the profitability of a project.
The solutions are proven but must be adapted to each project and negotiated well. As always, the devil is in the details and speed of execution can be critical. It is important to get support to deal in an efficient way with the best product for each situation, with the right documentation.
To do this, ESTER is your partner of choice.
