by Merijn Batteram
Introduction
In September 2014, a negative interest rate became applicable to the one and two week EURIBOR tenors for the first time in history. Currently, all EURIBOR tenors, from one week up to and including twelve months, reflect a negative interest rate. The same applies to the LIBOR rates. The impact of negative interest rates has therefore become more significant and widespread in recent years, in particular from a borrower's perspective.
In 2012, prior to the interest benchmarks becoming negative, the Loan Market Association (LMA) addressed the issue in its standard documentation for leveraged syndicated finance transactions with the introduction of an optional LIBOR / EURIBOR zero floor. Nowadays, it is market practice to include a zero floor provision in loan documentation with little to no room for borrowers to negotiate.
In this article, some background and guidance is provided in relation to negative interest rates, their impact on loan and hedging documentation and the inclusion of zero floors.
The influence of negative interest rates on LMA based loan documentation
The interest clause in loan documentation that is based on the LMA's recommended forms of facility agreements (for leveraged and investment grade financings) provides for the following components of interest:
- The Margin;
- EURIBOR or LIBOR; and
- Mandatory Costs, if any.
The aggregate of the above components is the interest payable on the loans drawn under the credit facilities. The Margin is set to a certain amount of base points (bps) and is therefore a fixed component of the interest rate. It is also possible that the Margin is set out in the form of a Margin grid, providing for various fixed levels of the Margin, whereby the applicable level depends on the outcome of a certain financial covenant (such as the Total Net Debt to EBITDA ratio).
The EURIBOR / LIBOR component is construed as a certain EURIBOR or LIBOR tenor, often the three or six month tenor. This is of course a floating interest rate component. Consequently, the aggregate interest payable on the loans is a floating rate. The Mandatory Costs fall outside the scope of this article.
The risk for lenders is that a negative EURIBOR / LIBOR interest rate erodes the Margin and thus the interest payable on each loan (and the return on investment for the lender).
Zero floor
In order to mitigate this risk for lenders, the market, in particular the LMA, has come up with optional wording to be included in the definition of EURIBOR / LIBOR, which generally reads as follows:
"EURIBOR" means, in relation to any Loan in euro:
- the applicable Screen Rate as of the Specified Time for euro and for a period equal in length to the Interest Period of that Loan; or
- as otherwise determined pursuant to Clause 17.1 (Unavailability of Screen Rate),
and if, in either case, that rate is less than zero, EURIBOR shall be deemed to be zero.
In case the applicable EURIBOR rate drops below zero, the EURIBOR rate will be set to zero for the purpose of the calculation of interest and in order to protect the lender's Margin.
The zero floor formulated above is the current market practice provision. The market has also developed two alternatives which borrowers may find to be more friendly: (i) the zero aggregate interest rate floor (setting the interest rate to zero only when the Margin has been fully eroded) and (ii) a zero floor for only that part of the credit facility which is not covered by the hedging agreement. Strong borrowers may seek to negotiate one of the alternatives.
An interesting question arises when the specific EURIBOR rate is negative to such an extent that it completely erodes the Margin and the underlying facility agreement does not include a zero floor provision. Would the lender then be obliged to pay the negative aggregate interest to the borrower? There is no case law in the Netherlands on this topic, save for a ruling of the Financial Services Complaints Tribunal (Klachteninstituut Financiële Dienstverlening (Kifid)) dated 31 March 2015. This ruling is not discussed in this article as it relates to a consumer case.
The LMA however has taken the position that if a zero floor has not been included in LMA loan documentation, there is still no contractual basis on which the borrower can claim payment of the negative interest from a Lender. The documentation does not provide for reversed interest payments, contrary to hedging agreements based on the ISDA formats. In any event, borrowers will be having a difficult time evidencing that they are entitled to receive a reversed interest payment from a lender on the basis of LMA loan documentation.
Negative interest rates and hedging documentation
Negative interest rates and zero floors also have an impact on hedging agreements, in particular the interest rate swaps. Borrowers are often obliged to undertake that a certain percentage (or all) of the outstandings under their term loan facilities are covered by a hedging agreement. Usually, one of the lenders also acts as hedge counterparty. By means of an interest rate swap, the floating interest rate under the loan documentation is swapped for a fixed interest rate. This protects the borrower against high floating interest rates, thus decreasing the risk on the loan for the lenders. In practice, the interest rate swap documentation will provide for payments by the hedge counterparty (or swap provider) to the borrower equal to the floating interest on its due date and, simultaneously, payments by the borrower to the hedge counterparty in the agreed fixed amount.
The references to the relevant benchmark rate, such as EURIBOR, to be received by the borrower from the hedge counterparty (as a part of the floating interest rate) are defined in the confirmation forming a part of the ISDA agreement (consisting of a master agreement, schedule and a confirmation). In order to align the amounts payable under the interest rate swap with a facilities agreement in which a zero floor is included, the definition of the benchmark rate in the interest rate swap confirmation should also include a zero floor provision. If this is not included (properly), a potentially very costly mismatch between the loan document and the hedging agreement arises. Unfortunately for borrowers, zero floor provisions are not incorporated in plain vanilla interest swaps. Due to back to back hedging by the hedge counterparty itself, hedge counterparties are usually reluctant to include such a provision in their swap documentation. In situations where hedge counterparties can be persuaded to do so (so called structured swap documentation), a zero floor provision often comes with significant costs for the borrower (sometimes outweighing the benefit of having a zero floor in the swap documentation altogether). Not surprisingly, borrowers often consider this to be unfair.
The risk of a mismatch
Borrowers should be aware of the risks involved with not incorporating a zero floor provision in their interest rate swap documentation while the underlying loan documentation does include such a provision. The problem for borrowers is that in a situation in which the benchmark rate becomes negative, this will affect the payment to be received by the borrower from the hedge counterparty while the interest payment to be made towards the lender will remain unaffected.
The borrower will, depending on the level of erosion of the Margin, either (i) receive an amount (Margin minus negative interest rate) from the hedge counterparty that is lower than the interest amount the borrower is obliged to pay to the lender under the facility agreement (Margin with benchmark rate set to zero) or (ii), in the event the Margin is eroded completely by the negative interest rate, pay (!) the hedge counterparty an amount equal to the negative interest rate minus the Margin. On the other end, the interest to be paid by the borrower to the lender under the facility agreement (with zero floor) remains unaffected. In such a situation, the interest swap can become a burden for the borrower.
Conclusion
Borrowers, in particular investment grade borrowers (who can negotiate lower Margins), must develop a strategy with respect to negative interest rates, zero floors and hedging documentation. The challenge is to estimate, within certain parameters, how low the interest rates can potentially go during the lifetime of the loan agreement. Subsequently, various scenarios (with and without zero floor) can be calculated in order to determine whether a structured interest rate swap is worth the additional investment.
In case you have any questions related to this topic or in case you would like to receive additional information, please contact Merijn Batteram.
by Merijn Batteram
Introduction
In September 2014, a negative interest rate became applicable to the one and two week EURIBOR tenors for the first time in history. Currently, all EURIBOR tenors, from one week up to and including twelve months, reflect a negative interest rate. The same applies to the LIBOR rates. The impact of negative interest rates has therefore become more significant and widespread in recent years, in particular from a borrower's perspective.
In 2012, prior to the interest benchmarks becoming negative, the Loan Market Association (LMA) addressed the issue in its standard documentation for leveraged syndicated finance transactions with the introduction of an optional LIBOR / EURIBOR zero floor. Nowadays, it is market practice to include a zero floor provision in loan documentation with little to no room for borrowers to negotiate.
In this article, some background and guidance is provided in relation to negative interest rates, their impact on loan and hedging documentation and the inclusion of zero floors.
The influence of negative interest rates on LMA based loan documentation
The interest clause in loan documentation that is based on the LMA's recommended forms of facility agreements (for leveraged and investment grade financings) provides for the following components of interest:
- The Margin;
- EURIBOR or LIBOR; and
- Mandatory Costs, if any.
The aggregate of the above components is the interest payable on the loans drawn under the credit facilities. The Margin is set to a certain amount of base points (bps) and is therefore a fixed component of the interest rate. It is also possible that the Margin is set out in the form of a Margin grid, providing for various fixed levels of the Margin, whereby the applicable level depends on the outcome of a certain financial covenant (such as the Total Net Debt to EBITDA ratio).
The EURIBOR / LIBOR component is construed as a certain EURIBOR or LIBOR tenor, often the three or six month tenor. This is of course a floating interest rate component. Consequently, the aggregate interest payable on the loans is a floating rate. The Mandatory Costs fall outside the scope of this article.
The risk for lenders is that a negative EURIBOR / LIBOR interest rate erodes the Margin and thus the interest payable on each loan (and the return on investment for the lender).
Zero floor
In order to mitigate this risk for lenders, the market, in particular the LMA, has come up with optional wording to be included in the definition of EURIBOR / LIBOR, which generally reads as follows:
"EURIBOR" means, in relation to any Loan in euro:
- the applicable Screen Rate as of the Specified Time for euro and for a period equal in length to the Interest Period of that Loan; or
- as otherwise determined pursuant to Clause 17.1 (Unavailability of Screen Rate),
and if, in either case, that rate is less than zero, EURIBOR shall be deemed to be zero.
In case the applicable EURIBOR rate drops below zero, the EURIBOR rate will be set to zero for the purpose of the calculation of interest and in order to protect the lender's Margin.
The zero floor formulated above is the current market practice provision. The market has also developed two alternatives which borrowers may find to be more friendly: (i) the zero aggregate interest rate floor (setting the interest rate to zero only when the Margin has been fully eroded) and (ii) a zero floor for only that part of the credit facility which is not covered by the hedging agreement. Strong borrowers may seek to negotiate one of the alternatives.
An interesting question arises when the specific EURIBOR rate is negative to such an extent that it completely erodes the Margin and the underlying facility agreement does not include a zero floor provision. Would the lender then be obliged to pay the negative aggregate interest to the borrower? There is no case law in the Netherlands on this topic, save for a ruling of the Financial Services Complaints Tribunal (Klachteninstituut Financiële Dienstverlening (Kifid)) dated 31 March 2015. This ruling is not discussed in this article as it relates to a consumer case.
The LMA however has taken the position that if a zero floor has not been included in LMA loan documentation, there is still no contractual basis on which the borrower can claim payment of the negative interest from a Lender. The documentation does not provide for reversed interest payments, contrary to hedging agreements based on the ISDA formats. In any event, borrowers will be having a difficult time evidencing that they are entitled to receive a reversed interest payment from a lender on the basis of LMA loan documentation.
Negative interest rates and hedging documentation
Negative interest rates and zero floors also have an impact on hedging agreements, in particular the interest rate swaps. Borrowers are often obliged to undertake that a certain percentage (or all) of the outstandings under their term loan facilities are covered by a hedging agreement. Usually, one of the lenders also acts as hedge counterparty. By means of an interest rate swap, the floating interest rate under the loan documentation is swapped for a fixed interest rate. This protects the borrower against high floating interest rates, thus decreasing the risk on the loan for the lenders. In practice, the interest rate swap documentation will provide for payments by the hedge counterparty (or swap provider) to the borrower equal to the floating interest on its due date and, simultaneously, payments by the borrower to the hedge counterparty in the agreed fixed amount.
The references to the relevant benchmark rate, such as EURIBOR, to be received by the borrower from the hedge counterparty (as a part of the floating interest rate) are defined in the confirmation forming a part of the ISDA agreement (consisting of a master agreement, schedule and a confirmation). In order to align the amounts payable under the interest rate swap with a facilities agreement in which a zero floor is included, the definition of the benchmark rate in the interest rate swap confirmation should also include a zero floor provision. If this is not included (properly), a potentially very costly mismatch between the loan document and the hedging agreement arises. Unfortunately for borrowers, zero floor provisions are not incorporated in plain vanilla interest swaps. Due to back to back hedging by the hedge counterparty itself, hedge counterparties are usually reluctant to include such a provision in their swap documentation. In situations where hedge counterparties can be persuaded to do so (so called structured swap documentation), a zero floor provision often comes with significant costs for the borrower (sometimes outweighing the benefit of having a zero floor in the swap documentation altogether). Not surprisingly, borrowers often consider this to be unfair.
The risk of a mismatch
Borrowers should be aware of the risks involved with not incorporating a zero floor provision in their interest rate swap documentation while the underlying loan documentation does include such a provision. The problem for borrowers is that in a situation in which the benchmark rate becomes negative, this will affect the payment to be received by the borrower from the hedge counterparty while the interest payment to be made towards the lender will remain unaffected.
The borrower will, depending on the level of erosion of the Margin, either (i) receive an amount (Margin minus negative interest rate) from the hedge counterparty that is lower than the interest amount the borrower is obliged to pay to the lender under the facility agreement (Margin with benchmark rate set to zero) or (ii), in the event the Margin is eroded completely by the negative interest rate, pay (!) the hedge counterparty an amount equal to the negative interest rate minus the Margin. On the other end, the interest to be paid by the borrower to the lender under the facility agreement (with zero floor) remains unaffected. In such a situation, the interest swap can become a burden for the borrower.
Conclusion
Borrowers, in particular investment grade borrowers (who can negotiate lower Margins), must develop a strategy with respect to negative interest rates, zero floors and hedging documentation. The challenge is to estimate, within certain parameters, how low the interest rates can potentially go during the lifetime of the loan agreement. Subsequently, various scenarios (with and without zero floor) can be calculated in order to determine whether a structured interest rate swap is worth the additional investment.
In case you have any questions related to this topic or in case you would like to receive additional information, please contact Merijn Batteram.