Unthinkable 12 months ago, the possibility of negative interest rates is now very real. What does that mean for corporate treasury functions?
The Reserve Bank of New Zealand (RBNZ) has clearly voiced its willingness to use negative interest rates in helping stimulate the New Zealand economy. The impact of this is already reflected in New Zealand government bond yields which sank to minus 0.06% in September.
Although the decline in interest rates is likely to result in an overall reduction in the cost of funding for organisations, there are several unintended consequences of this type of monetary policy. Organisations should now be considering the implications of negative interest rates and directors will need to ensure that these are appropriately considered by management and communicated to stakeholders.
Heading into the COVID-19 crisis, the official cash rate (OCR) set by the Reserve Bank of New Zealand (RBNZ) was at a record low. The RBNZ responded to the crisis in March 2020 with an emergency OCR cut from 1.0% to 0.25%, bringing New Zealand as close as we have ever been to negative interest rates.
In May 2020, the RBNZ signalled its willingness to take the OCR into negative territory when it advised New Zealand banks that, by the end of the year, the RBNZ would be assessing the banks’ abilities to manage in a negative interest rate environment.
The expectation of negative interest rates in New Zealand has already become a reality as current market activity reflects negative yields. For example, the yield on the benchmark five-year government bond fell to minus 0.06% and some tenors of New Zealand wholesale swap rates also fell below zero for the first time in September.
What impact will this have on corporates managing their interest rate risk?
Corporates usually obtain floating rate funding that is priced at base rate plus a credit margin. To achieve a fixed cost of borrowing, corporates hedge their interest rate exposure to the base rate using a float-to-fix interest rate swap (IRS).
In a negative interest rate environment this would mean that the cost of borrowing is less than the credit margin. However, to avoid this arbitrary outcome, lending arrangements usually contain a zero floor. The zero floor provides that, if the base rate (ie Bank Bill Benchmark rate or BKBM) is negative, it is deemed to be zero for the purposes of calculating interest under the agreement. However, no such clause exists in the interest rate swaps, resulting in the breakdown in the economics of the hedge.
For example, if the underlying interest rate on a borrowing facility is 0.75% above BKBM, the minimum cost of funding will be 0.75% as the loan agreement is likely to have zero floor. Therefore, even if the BKBM goes negative the benefit is not passed on to the borrower.
Borrowers tend to want certainty over their cost of funds and typically use derivatives such as interest rate swaps to convert floating interest rates to fixed interest obligations. Often, these derivatives do not have similar floors to those embedded in the borrowing facility agreements. What this means is that if interest rates become negative, it is likely that the floating interest the borrower receives on the interest rate swaps may not match the interest rate paid on the facility/loan, resulting in borrowers paying more than the expected fixed rate.
Case study on the cost implications
A borrower enters a “pay 2% fixed, receive BKBM” interest rate swap to hedge a bank facility with an interest rate of BKBM +0.75% (the facility contains a 0% floor on the BKBM rate).
The table shows that for positive BKBM rates, movements in the IRS and bank facility rates exactly offset each other, therefore the borrower is locked into paying a fixed rate of interest (a fixed rate of 2.75% in this example). However, due to the floor on the bank facility, as the BKBM decreases below 0%, this relationship breaks down and the net interest rate paid increases.
How low can negative go?
This net interest increase is driven by how negative interest rates go – global experience has indicated that negative interest rates beyond a certain point (in some cases, interest rates beyond negative 0.75%) provide little benefit from a monetary stimulus perspective.
The biggest challenge that corporates have to consider is the length of time that rates will remain negative, as this will drive their interest rate risk management strategy.
Negative interest rates will not only impact the cost of borrowing for corporates, there are wider implications particularly for those corporates that hedge account under IFRS 9 – Financial Instruments.
What impact will this have on financial statements?
Under accounting standard IFRS 9, one of the key conditions in order to be able to apply hedge accounting, is that there is an economic relationship between the hedged item (borrowing or bank facility) and hedge instrument (interest rate swap).
When interest rates are positive, an economic relationship can be assumed to exist if for example, a 1% movement in the hedging instrument results in an equal and opposite 1% movement in the hedged item.
However, in a negative interest rates environment this relationship between the hedged item and hedging instrument no longer holds. This is because the zero floor on the hedged item (bank facility) limits the rate on the instrument to further decreases, whilst the hedge instrument (interest rate swap) has no such limit. As explained earlier, this not only results in a breakdown of the required economic relationship, but in the failure of the hedge relationship. The consequence of this is an enhanced level of profit and loss volatility.
The primary step that a business should take is to review the terms and conditions of its debt facilities/loan covenants, to determine the extent to which there are floors written into the borrowing agreements.
If a business determines that it will be impacted by a mismatch between the debt facilities/loans, there are several options that could be considered.
Each option has both benefits and costs, and the best course of action is dependent on a combination of aspects such as risk tolerance/appetite and market expectations.
The decision that a business takes in managing the impact of negative interest rates should be guided by the limits and parameters articulated in its treasury policy. The policy should reflect the appetite of the board to accept the risk of interest rate variability.
If you are uncertain as to the impact of negative interest rates on your organisation and whether your treasury policy is fit for purpose, we recommend that you seek expert advice from a treasury professional.