Can interest rate risk be properly covered in case of a financing with extension options?
Extension options
Today, many of our clients take out financing with “extension options”. The customer often has the option of asking the bank(s) twice to extend the term of the financing by one year. For example, if it concerns a 3-year financing that can be extended twice by 1 year up to a maximum of 5 years, we also speak of a "3+1+1" financing. When it comes to a 5-year financing that can be extended to a maximum of 7 years, we speak of "5+1+1" financing.
In the previous paragraph we deliberately speak of “asking the bank(s)” because such an extension is always subject to approval by the bank. However, if there are no special and/or negative developments in terms of creditworthiness with the customer, this approval is usually given. In other words, with a 3+1+1 financing, both parties (customer and bank) usually intend to enter into a relationship for 5 years. The same applies to a 5+1+1 financing. There the intention is to enter into a relationship for 7 years. The main reason that companies use financing with extension options is the maximum term that is common in the market. Banks go for a maximum of 3 or 5 years for certain sectors, but are almost always willing to add extension options. In that case, this supplement is a “free option” for the company to spread the upfront costs and time effort of arranging financing over a longer term.
Interest risk
It is of course nice to have extension options to create flexibility in terms of financing. In this way, it is easy to respond to the development of the company's financing needs. However, the interest to be paid on a financing is usually linked to a variable benchmark (usually €STR or EURIBOR). So therefore, the question then arises how we can hedge the interest rate risk when the tenor of the financing is uncertain? Is the company willing and able to also hedge the period of the extension options? And is it all that easy with the bank? For the sake of simplicity, let's assume a 3+1+1 financing and a company that is looking for security in terms of interest charges and would like to conclude a fixed-floating interest rate swap (the analysis is not fundamentally different with an interest rate cap, by the way).
Interest rate risk on renewal
The most logical choice seems to be to hedge the interest rate risk for 3 years. After all, in principle, the loan only runs for 3 years. But what if we now know that the company plans to exercise the extension options and it is also expected that the bank will go along with it? As of today, the company is therefore exposed to the risk that the variable interest rate rises in the 4th and 5th year. Unfortunately, we don't have a crystal ball, but we can imagine that entrepreneurs like to have certainty about the variable interest in those last years.
Then why don’t you just hedge for 4 or 5 years, we hear you think. But that turns out not to be so easy. Due to the duty of care responsibilities, a demonstrable 1-to-1 link between the financing and the interest rate swap is important for banks and supervisors. This means for example that the nominal value of the swap may not exceed the size of the (outstanding) loan. In addition, it also underlies the principle that a bank does not want to have an interest rate swap on its books with a customer with whom there is no (longer) financing relationship. This principle is strictly enforced by most banks. So, in case the financing is not extended and therefore expires after 3 years, while at the same time a 4 or 5 year interest rate swap has been concluded, this principle would be breached. This would lead to a “loose swap” in banking parlance.
The possibilities of hedging the interest rate risk in the years 4 and 5 with products in the “option sphere” such as interest rate caps, swaptions or extendable swaps often prove to be undesirable. They require payment of an upfront (option) premium. Here too, the banks remain critical of the lack of the link between the derivative and the loans in the event that they are not extended.
A solution
One possibility to solve this issue, which we have recently applied in the market, is the following. The customer concludes an interest rate swap with the bank(s) for 5 years. This mitigates the risk of rising interest rates over the entire 3+1+1 period. We then agree with the banks that we will include an “early termination” option in the confirmation of the interest rate swap. Both parties, the company and the bank, are free to exercise this option. The settlement dates of this option are fully aligned with the option to extend the financing by a 4th and 5th year of your choice. In this way we guarantee that there is always a perfect match between the financing and the interest rate swap.
What does this mean in practice? If the financing is not extended by 2 years (+1+1), but expires after 3 or 4 years, the market value of the interest rate swap will be settled between the company and the bank when the financing expires. This can result in a negative or positive cash flow for the company, depending on the interest rate development. However, this is not the base scenario. The base scenario is of course that the financing is extended to 5 years and the swap also runs for 5 years. The key point of the early termination option is that the bank has 100% comfort that no “separate swaps” can arise as a result of not extending the financing.
The development of this solution must be done in close contact with the relevant experts of the bank (credit specialists, lawyers, etc.) to ensure that the financing and the hedge match perfectly. Another point is that when the company uses hedge accounting, its own accountant must also be involved in time to guarantee its continued application.
Are there any drawbacks to this solution at all? Actually, little. What may of course happen is that the interest rate swap has to be settled early after 3 or 4 years in case the financing is unexpectedly not extended. The market value must then be settled. If the interest in the 4th or 5th year is actually lower than what is now priced in in the 5-year swap, this market value settlement will be negative. Meaning, it leads to a payment by the company to the bank. In view of the currently still relatively low interest rates, this seems to be a fairly manageable risk for a company that in principle wants to enter into financing for 5 years.
We would be happy to discuss your company's interest rate risk and the options available to manage this risk.
Article written by Alwin de Haas from Orchard Finance. Alwin is a partner at Orchard Finance and a specialist in the fields of debt advisory and corporate risk management.