Record low rates

Forward starting hedge

• The FOMC’s focus on lowering US unemployment has led the Fed to provide conditional guidance on maintaining low rates over the next few years.
• Expectations for future 3 month Libor rates per the futures market have fallen sharply as a result, and have nearly eliminated the costs associated with locking in term funding rates.
• As the graph above illustrates, the rate to fund 3 month vs. 3 years has virtually converged. It’s unlikely swap rates out to 3-years can decline much further given the practical lower limits of 0%.
• Borrowers that take a longer term view of rate exposure can lock in funding costs on a forward starting basis. The hedge contract would have a start date one or two years from today, and allow the borrower to remain floating (with or without a rate cap) while locking in term rates for a specific period of time. This strategy provides the borrower with rate certainty for a future time frame while locking in today’s pricing.

• If a borrower is refinancing an existing loan that has been hedged, and is arranging new financing with a different lender, it may face early termination costs associated with the hedge.
• The magnitude of termination costs are driven by the amount hedged, the remaining term of the hedge, and the current market pricing relative to where the hedge was initially executed.
• Borrowers can approach the new lender to determine whether the existing contract can be maintained, and assigned as part of the new financing.
• If successful this strategy allows the borrower to keep the hedge and not be forced to pay hedge breakage cost to the original lender.