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Hedging loans – how fluctuating interest rates may play out? 

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    • When will interest rates start to fall? 

    • Is it higher for longer or indeed lower but slower?

    • Has the battle vs inflation been won?

    All of these questions remain the subject of considerable debate among economists, politicians, advisors and loan market practitioners and the answers seem to vary week to week as the market reacts to economic data and/or central bank pronouncements.

    What is certain is that rising interest rates during 2023 had a profound effect on behaviour across debt markets.

    In October 2022, as the UK loan market was getting used to SONIA as opposed to LIBOR, base rate in the UK stood at 2.25% having risen from its pandemic low of 0.1% over the course of the year. Forecasts at the time suggested it would increase to somewhere around 5.5% to 6% by mid-2023. Whilst this proved to be slightly overly pessimistic (unless you are a saver), base rates have seemingly peaked at 5.25% and, its financial market proxy, SONIA now stands at 5.19%. Putting this into sharper perspective in terms of the corporate and leveraged loan market, every £10m borrowed is now costing c£500,000 per annum more in interest payments and that is before any potential increase in margin associated with a tightening market.     

    Two natural considerations of higher underlying interest rates are financial covenants and hedging:-

    Financial covenants – higher rates bring an increased risk of financial covenants being under pressure, particularly those covenants focused on debt service. Evidencing future compliance would have been more difficult for borrowers given how rapidly rates were rising and, looking forward, the uncertainty over how rapidly rates will fall adds a further variable to cashflow forecasting.  Therefore, rising debt service costs, as well as wider market headwinds, will have lenders looking very closely at the total level of debt being sought by borrowers.

    Hedging – those borrowers who hedged prior to the autumn of 2022 will have been at the head of the queue for a pat on the back from their boards. That said there will have been many caught out by the sheer pace of rate rises around the world (for example, the UK base rate was increased at 14 consecutive meetings of the Bank of England's Monetary Policy Committee from December 2021 to August 2023) and would have missed the opportunity to hedge in whole or in part. Despite the above pressures, mandatory hedging as part of loan of agreements does not appear to have re-emerged as a market requirement.  This may be partly explained by the speed of the rates rises.  By the time the market had caught its breath as to how to manage hedging, rate rises had levelled off and the immediate concerns had abated.    

    Nonetheless, as we write, the opportunities to hedge look attractive, even if not on a mandatory basis, with the market anticipating a fall in rates and again timing will be key. Factors to bear in mind are:

    • Security/ranking: In secured transactions, hedging providers will want to share the same security package either on a priority basis (i.e., super senior) or alongside existing lenders (i.e., pari passu).  Although LMA based transactions will often contemplate secured hedging, any loan agreement executed before 2022 is unlikely to have had hedging at the forefront of mind during negotiation.  As such, borrowers can anticipate that hedging providers may need to amend the documents to align with policies – even where those providers are already a party to the document as a lender.  Any such amendments would also need to be agreed with the other lenders which may have timing consequences.
    • Hedging caps: Where it is agreed that hedging will be secured on a priority basis, the non-priority lenders will require that such hedging is only capped up to an agreed amount (the hedging basket).  Historically, when minimal hedging has been done, or such hedging was unrelated to interest (e.g., day-to-day FX hedging), such baskets were relatively small and stable.  However, due to higher and more volatile interest rates, hedging providers are requiring materially higher baskets (and, in some cases, multiples of previous baskets). In some cases, the priority hedging may even be uncapped provided that such hedging relates to the secured term debt.  Existing lenders will need to be comfortable with hedging ranking ahead of them up to these increased levels.
    • Voting:  Larger hedging requirements and larger hedging baskets have also shifted the voting dynamics and lenders now need to be keenly aware what voting influence a hedge provider might be able to exercise to the extent they are able to vote (typically, hedging providers only vote on closed out positions and not mark to market values). In our experience, lenders are particularly focused on this when hedging is not provided by one or more of the existing lenders and therefore its only consideration is its hedging position.

    Looking forward, it is a fool's errand to forecast with any confidence where rates will be at the end of the year but there is little doubt that they will be lower than they are today. This will take some pressure off borrowers, reducing costs and there is considerable hope that this is one factor that will drive an increase in M&A which will in turn lead to more activity in both loan and bond markets. 

    As ever communication is key in what remains a relationship driven market.  Ashurst has extensive experience across all asset classes on both borrower and lender side and our partners and lawyers work seamlessly across loans, bonds and hedging products.

    We would be delighted to help you – please do give us a call. 

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