Can interest rate risk be properly hedged when financing with extension option(s)?

Extension options

Today, many of our clients conclude their financing with “extension options.” Often the customer has the option twice to ask the bank(s) to extend the term of the financing by one year. For example, if it is 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. If it is a 5-year financing that can be extended to a maximum of 7 years we speak of “5+1+1” financing.

We deliberately speak of “ask the bank(s)” in the previous paragraph 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 the customer’s creditworthiness, 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 5-year relationship. With a 5+1+1 financing, the same is true. 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 financing term common in the market. Banks go to a maximum of 3 or 5 years for certain sectors but are almost always willing to add extension options to that. In that case, this addition is a “free option” for the company to spread the upfront cost and time effort of arranging financing over a longer term.

Interest rate risk

It is of course nice to have flexibility in financing in terms of maturity. In this way, it is easy to respond to the development of the company’s financing needs. However, the interest rate payable on financing is usually linked to a variable benchmark (usually €STR or EURIBOR). The question then arises how to hedge the interest rate risk? Is the company also willing and able to 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 seeking certainty in terms of interest costs and eager to enter into a fixed-floating interest rate swap (with an interest rate cap, by the way, the analysis is not significantly different).

Interest rate risk at renewal 

The most logical choice seems to be to hedge the interest rate risk for 3 years. After all, the loan basically runs for only 3 years. But what if we now know that the company intends to exercise the extension options and the bank is expected to go along with this? So then, as of today, the company is exposed to the risk that the variable interest rate will increase in the 4th and 5th year. Unfortunately, we do not have a crystal ball, but we can imagine that entrepreneurs would like to have certainty about the variable interest rate in those final years.

Then just hedge for 4 or 5 years, we can hear you think. But that turns out not to be so easy. For banks and supervisors, a 1-to-1 link between the financing and the interest rate swap is important from a duty of care perspective. This means that the nominal value of the swap may not exceed the size of the (outstanding) loan. In addition, a bank does not want to have an interest rate swap on its books with a customer with whom no financing relationship exists (anymore). If the financing is not renewed and therefore expires after 3 years, and a 4 or 5 year interest rate swap is concluded, this would be the case. This would lead to a “loose swap” in banking parlance.  

The possibilities of hedging interest rate risk in years 4 and 5 with products in the “option sphere” such as interest rate caps, swaptions or extendable swaps also often prove to be undesirable. They require payment of an upfront (option) premium. Again, banks remain critical of the lack of linkage between the derivative and the loans in case they are not extended.

A solution

A possibility to solve this issue, and one which we have recently applied in the market, is the following. The customer enters into an interest rate swap with the banks for 5 years. This mitigates the risk of rising interest rates over the entire 3+1+1 period. We then agree with the banks to 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 possibility of extending the financing by a 4th and 5th year. 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, a settlement of the market value of the interest rate swap takes place between the company and the bank at expiration of the financing. This can generate a negative or positive cash flow for the company depending on interest rate trends. However, this is not the base case scenario. The base case, of course, is that the financing is extended to 5 years and the swap also runs for 5 years. The point of the early termination option is that the bank has 100% comfort that no “loose swaps” can arise from not extending the financing.  

The development of this solution must be done in close contact with the relevant experts at the bank (credit specialists, lawyers, etc.) to ensure a perfect match between the financing and the hedge. Another point is that when the company uses “hedge accounting,” its own accountant must also be engaged in time to ensure its continued application.

So are there no drawbacks to this solution at all? Not much, actually. What can of course happen is that the interest rate swap has to be settled early after 3 or 4 years if the financing is unexpectedly not extended after all. The market value must then be settled. If the interest rate in the 4th or 5th year is then actually lower than what is now priced into the 5-year swap, this market value settlement will be negative. That is, lead to a payment by the company to the bank. Given the current low interest rates, this seems like a fairly manageable risk for a company that in principle wants to take on 5-year financing.  

We would be happy to discuss with you your company’s interest rate risk and the possibilities to manage this risk.