Embedded floors can increase your risk and your interest expense.
Lenders have begun limiting their commercial customers from accessing the full extent of low market-based borrowing base rates, such as LIBOR. This policy pushes the lender’s risk onto you, and it’s not related to your own creditworthiness.
But, there are strategies that can be applied to mitigate this dubious policy.
Banks that lend to small and medium-sized businesses are looking to add a minimum – a lower limit – to the all-in interest charged in their floating rate loans. This is occurring in some larger syndicated loans, as well. Lenders are doing this through setting a floor on the base borrowing index in the loan, which is typically LIBOR, or by setting a minimum on the all-in interest rate. But even when the floor is set on an all-in interest rate basis, a floor is implied on the borrowing base index.
Lenders are essentially having their borrower customers provide a concession without the borrower being compensated for it. These embedded floors are primarily a lender’s defense against the market risk of borrowing base rates dropping too low or even negative. The market has never seen negative USD LIBOR rates, but this has occurred in baseline borrowing indices in other currencies.
The embedded LIBOR floors in loans (whether they be directly set on LIBOR itself or implied through the all-in rate) typically range today from 0% to 1%.
The exposure that a lender has with low or negative rates is that at some point the base index rate in their loans will no longer match up with the bank’s funding cost, which is typically their deposit rate. In other words, it’s possible the cash a lender pays (deposits) might exceed what it receives (loans). This would effectively reduce the lender’s risk returns across their lending portfolio and put them into financial jeopardy.
In other words, through the application of embedded loan floors, lenders are asking borrowers to mitigate a market risk, which is unrelated to the unique credit risk of their borrowers, for free and at the expense of their customers.
So, the question is what can a borrower do, if anything, to alleviate the existence of an embedded floor in their loan?
Below are three potential strategies.
When imposing an embedded floor, your lender is taking a free option
The embedded loan floor is an interest rate option that has a corresponding option premium value. This floor option is something the bank either has, or is asking to have, for free. Given this, some lenders are willing to negotiate these embedded floors.
In some cases, lenders will waive the floor if the borrower enters an interest rate hedge. The waiver allowance typically matches the notional amount and the term of the hedge put in place.
If lenders will not waive the floor entirely, they may perhaps lower the effective LIBOR floor to 0% if the loan calls for an even higher floor rate. In this case, the floating rate borrower that hedges with a typical LIBOR-based interest rate swap still maintains the risk that LIBOR turns negative.
This is because under a standard ISDA agreement, the “Negative Interest Rate Method” applies by default to an interest rate swap, unless the parties specify otherwise. Under the Negative Interest Rate Method, if the floating rate leg under the swap is negative, the borrower that is hedging floating rates by paying the fixed leg of the swap would also be obligated to pay the absolute value of the floating leg for the applicable payment period as opposed to receive any floating rate payment. This will occur while the borrower fails to receive any offsetting relief from the lender that has an embedded floor under the loan. Therefore, what this means is that an interest rate swap could turn into a pay fixed rate plus pay a floating rate swap under a negative LIBOR scenario, thus increasing interest rate expense and increasing risk to floating rates as opposed to reducing risk.
A way around this is to negotiate the application of the “Zero Interest Method” into the ISDA agreement to address negative interest rates. As opposed to the Negative Interest Rate Method, The Zero Interest Method provides that if the floating leg of the swap is negative, the borrower who is hedging its floating rate is obligated to only pay the fixed leg of the swap for the applicable payment period and does not have to make an additional payment on the negative floating rate leg.
2. Buy back the floor
Embedded floors can be reversed with offsetting hedges
A strategy that is becoming more common is for the borrower to buy the floor option back from the lender, especially when the embedded floor is struck at 0%. The current at-the-money strike for a two to three-year floor is around 0.25%, the same as the interest swap rate for this term. Therefore, a 0% LIBOR floor option is not a very expensive proposition because at that strike level this shorter-term floor is currently out-of-the-money. If the floor option that needs to be bought back has a strike level closer to 0.50-1.00% or more, this strategy becomes progressively more expensive as these higher strike options are all currently in-the-money.
This strategy can be done on a stand-alone basis or combined with executing an interest rate swap. When done alone, the borrower must pay a premium, typically upfront, for buying back the floor option from the lender. When done in conjunction with an interest rate swap, the cost to buy back the floor can be embedded in the fixed swap rate, raising the fixed swap rate enough to offset the hedge dealer for the present value of the upfront floor option premium they are otherwise due to receive.
3. Create a collar or synthetic swap
Convert the embedded floor into an interest rate hedge
By buying an interest cap option, combined with the embedded floor option already in the loan, the borrower creates an interest rate collar. In the case of a LIBOR option, the borrower’s base LIBOR rate in the loan will not drop below the embedded loan floor strike just as it will not rise above the purchased cap strike.
When a cap option is purchased with the same strike as the floor option, the borrower has synthetically created an interest rate swap, with the fixed swap rate equal to the two offsetting floor and cap strikes.
For example, borrowers who have 1% embedded LIBOR loan floors can purchase a LIBOR cap option struck at 1%, thus creating a synthetic swap with a fixed rate of 1%. If LIBOR is below 1%, as it currently is across all various LIBOR maturities, the borrower’s base index in its interest expense stays at 1% due to the embedded loan floor. Alternatively, if LIBOR increases above 1%, the borrower’s base index in its interest expense stays at 1% due to the purchased cap. Hence, base LIBOR will always remain at 1%, which is the same as if the borrower hedged with a LIBOR interest rate swap with a fixed rate of 1%.
In either case of creating a collar or a synthetic swap, the borrower must pay a premium, typically upfront, for buying the cap option.
Although such a synthetic swap is likely going to be set above current market interest rate swap levels and comes at the cost of the option premium, the advantage of this synthetic version of an interest rate swap is that the borrower does not face negative LIBOR rate risk discussed above.
Embedded interest rate floors in loans are free options to lenders. They exist to protect the lender, not the borrower. In fact, in some of the examples provided, embedded floors increase the interest rate cost and the interest rate risk to the borrower.
Lenders vary on many issues, including their degree of willingness to negotiate these floors. When a lender refuses to negotiate, there are still strategies a borrower can apply to mitigate the adverse effects of these embedded floors. However, most of these strategies entail a cost, either through higher hedge rates or upfront payments.
So, be very aware of embedded floors in your loans and their potential implications, especially when it comes to hedging your floating rate risk. For specific recommendations, full-service clients should contact email@example.com.