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What happens when interest rates hit the floor?

Amid challenges facing central banks in keeping the economy open for business, zero or negative benchmark interest rates are a real possibility. Let’s consider what that means for business.

       

 

What’s happening?

On 1 October, the Reserve Bank of Australia (RBA) announced another interest rate cut. It is the third cut within five months and brings the cash rate to 0.75 of a percentage point, the lowest level in Australian history. The RBA has indicated that it is willing to take extraordinary steps to boost the economy, decrease unemployment and push the inflation rate back within the target bands.

Expectations of further cuts in Australia could become a reality after the US Federal Reserve cut its benchmark rate by 25 basis points in September.

Negative interest rates might sound odd, but they have been seen previously in the central banks of Switzerland (’70s and 2014), Japan (early ’90s), Sweden (2009 and 2010), Denmark (2012) and the European Central Bank (2014).

What does it mean in theory?

A zero, or negative, interest rate would appear to be counterintuitive to core financial and economic principles. Theoretically, this could result in banks actually paying customers for borrowing from them.

What’s the real impact?

Sadly for customers, a negative benchmark rate does not mean free money or a paid-for mortgage. Generally, banks will include a zero, or minimum, interest rate floor clause in a debt facility to guarantee a minimum level of interest earned. This is even if the bank bill swap rate (BBSW) or other floating rates become negative.

However, what borrowers need to watch out for is interest rate swaps they may have used to lock in interest on their floating rate loans. Often, such swaps don’t have a similar floor.

In this situation, it’s possible that future cash flows for the loan and the interest rate swap will no longer match.

Critically, this means fixed loan rates might not actually be fixed: borrowers may actually end up paying more than their fixed rate.

We use the following scenarios to illustrate this effect.

Company borrows $1 million from Bank at a floating rate of BBSW + 2%. The loan has a floor so total interest cannot drop below 2%, even if BBSW was negative. To fix its interest rate, Company also purchases an interest rate swap to lock in a fixed rate of 4%. Under the swap, Company receives BBSW + 2% and pays 4% fixed. The swap has no floor.

Scenario 1 – BBSW is 1%, so bank variable interest rate is 3%

Scenario 2 – BBSW is -2%, so bank variable interest is 2% (because of the floor)

 

Scenario 1 – Net outflow: $40,000

Scenario 1: 
BBSW (1%) is greater than the floor (0%)

Interest Rate Swap: Company pays

Interest Rate Swap: Company receives

Interest on debt: Company pays

Net effect: Company pays

Exposure to the floating rate is 100% hedged

Fixed 4% under the terms of the Interest Rate Swap

 

Variable 3%, comprising 1% BBSW + 2% fixed

 

Variable 3%, comprising 1% BBSW + 2% fixed

Fixed 4%


Scenario 2 – Net outflow: $60,000

Scenario 2:
BBSW (-2%) is less than the floor (0%)

Interest Rate Swap: Company pays

Interest Rate Swap: Company receives

Interest on debt: Company pays

Net effect: Company pays

The floor limits the volatility of the loan which is not offset by the Interest Rate Swap. The hedging relationship is not effective

Fixed 4% under the terms of the Interest Rate Swap

0%, comprising -2% BBSW + 2% fixed

 

Variable 2%, comprising 0% BBSW (limited by the floor) + 2% fixed

Total 6% interest, being fixed 4% AND 2% (i.e. interest on debt)

 

In Scenario 2, Company may have thought it was locked into a fixed interest rate. However, because of the floor, their net interest is actually 6 per cent!

What might borrowers do?

In order to manage the exposure to negative interest rates in the situations above, borrowers can include interest rate floors along with swaps when entering into new debt agreements.

For existing swaps, borrowers could purchase a floor (by way of a purchased option) to try to manage interest rate exposures if benchmark rates did actually go negative. 

What are the accounting implications?

Although rates have fallen to an all-time low, Australia has never actually had negative interest rates.

However, if the curve begins to turn, ineffectiveness may arise from hedging relationships which, in certain circumstances, require hedge accounting to be discontinued — with consequent significant potential profit and loss (P&L) statement volatility.

Depending on a company’s particular circumstances, the outcomes could be:

Continue hedge accounting but separately account for the floor interest

This means that:

  • hedge accounting would not be precluded, but
  • the floor derivative is marked to market through the P&L statement.

The financial instruments standard provides an example where an embedded floor on the interest rate on a debt contract is not separated, provided the floor is at or below the market rate of interest when the contract is issued. If the floor is above the market rate of interest when the contract is issued, then it should be separately accounted for (i.e. if it is “in the money”).

Separation of the floor does not mean hedge accounting necessarily fails. However, where separation is required, the floor is accounted for at fair value through the P&L statement.

Discontinue hedge accounting

If this occurs:

  • hedge accounting is discontinued prospectively, and
  • existing cash-flow hedge reserves remain and are recognised in the P&L statement in the normal course.

Whether hedge accounting can be achieved will depend on the circumstances. If there is a floor, which is not separated from the debt instrument, and there is no equivalent floor in the hedging instrument, ineffectiveness will result from the hedging relationship.

The extent of the disconnect between the floating rate and the floor could require discontinuation of hedge accounting where there is no longer an economic relationship between the hedged item and the hedging instrument; for example, where the variable rate is lower than the floor for a substantial period of the hedging relationship.

What can you do to prepare?

If your business is exposed to interest rate risk, regardless of whether you are a lender or borrower, it is important to be aware of the possibility of having a zero interest rate environment and what the accounting implications might be. Check your contracts. If you do have a floor, think about whether you need an additional option or swap to protect your interest profile.

 

Insights: David Waters, Manuel Kapsis, Fei Huang and John Ratna
PwC Australia 
11 October 2019 
Reported in the accountantsdaily.com.au

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