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Liquidity & re-pricing risks in derivative portfolios: Strategies to deal with mandatory break clause

Critical steps within corporate finance planning when considering Mandatory Break Clauses are 1. Awareness of the impact of upcoming derivative break clauses, 2. Strategic planning on the approach which best fits with corporate finance and treasury objectives, and 3. Execution of plans.

There are strategic implications to potential outcomes from a corporate treasury perspective. Less efficient solutions can lead to long term inefficiencies in debt and derivative portfolios, impacting profitability, credit metrics and therefore shareholder distributions.

It is critical that implications and risks are understood by boards, due to the need for efficient decision making, and associated financial impacts.

Companies are now holistically analysing interest rate and inflation exposures between the corporate balance sheet and the sponsors pension scheme and are reviewing internal solutions.

Key considerations

  • The issue: Break extension costs in swap contracts are significantly higher than 2015 caused by changes in banking regulation, bank funding costs and underlying swap mark to market positions;
  • The corporate finance risks: Risks of materially higher costs due to inefficient use of capital (through not utilising an optimal pool of counterparties who can offer value for money). Risks of inadequate replacement agreements leading to balance sheet volatility;
  • The environment: There is limited efficient capacity available within many of the legacy banking groups. New banks with no existing exposures could potentially deliver more efficient capital and deliver lower pricing and longer break dates.
  • Specialist advice: This is highly likely to add value in achieving the optimal outcome and requires:
    • Detailed understanding of the business model and the existing debt and derivatives portfolios.
    • Comprehensive analysis of the options, the cost of options, and the spectrum of bank and institutional counterparties available.
    • Understanding senior management risk appetite drivers and business objectives.
    • Understanding the documentation, tax and accounting constraints.
    • Track record of executions / support and planning of executions.
  • Understanding the options available including more recent developments such as direct novation to institutions, institutional capital and the requirement for hedging.

What are the options available?

Structural change to alter arrangements to make them more efficient or cheaper and negotiate with existing bank:
• Altering the structure to be less capital and funding intensive
• introduce some form of security through guarantees or form of collateral

Traditional SPV Re-packaging: Work with existing bank to re-package to allow for an efficient solution, where the inefficient components are passed to a 3rd Party. This will need to take into account:
• Availability of third parties willing to cover the offsetting position
• Affordable costs
• Structural and operational synergies
• Accounting and tax

New Bank Capital: Approach new bank counterparties if they can provide greater efficiencies through their balance sheet:
• Breaks link with existing counterparty
• Utilises balance sheets without large exposures
• Retains the ability to allow for Re-packaging of existing risks

Potential to novate the entire or portions of the contract directly to an institutional investor:
• Still in early stages
• Whilst institutional investors are natural counterparties to house many risks, the balance of such risks may not be appropriate
• Potential operational concerns
• Structural concerns with risks which may not be acceptable to counterparties

What are the costs of such decisions?

The impacts of putting in place many of the options above will have inherent costs, and these should be understood and evaluated as part of a decision-making process.  These can be split into the following considerations:

  1. Existing covenants: the impact of providing collateral, changing seniority, or regular rebalancing may be restricted by existing hedging or financing agreements, and the flexibility to enter future arrangements;
  2. Liquidity considerations: due to refinancing out of the money positions or introduction of some form of cash collateral;
  3. Credit rating agencies: does the action make the business riskier, and could this result in a downgrade? Are there subsequent costs associated such as higher future borrowing costs?
  4. Accounting costs: the impact on financial instruments accounting;
  5. Operational costs: the cost and risks associated with the operational infrastructure required to manage and maintain.

A full analysis of existing treasury management and hedging policies can help clients minimise the impact of upcoming break clauses on their financing and hedging requirements

An example of the variability in costs, and the importance of understanding the wider market

As an example of recent pricing, the anonymised chart below shows the pricing differentials between different bank counterparties pricing a maximum tenor of mandatory break extension, against an annualised coupon uplift / cost, and reflecting the variation in different bank’s maximum capabilities for extension:

An understanding of the entire counterparty market, and the processes required to optimise re-pack outcomes is key to identifying the best home for existing arrangements

The most efficient solution often requires thinking outside the box

Finding the most efficient solution requires a full and detailed understanding of the existing counterparty’s risk appetite and is necessary to find optimal solutions for clients to give the restructuring / re-pack process the best chance of an optimal outcome.

Recent processes have considered the sponsors’ own pension scheme as a potential investor to support a re-pack exercise. Such a transaction would strongly support the principles of holistic risk efficiency within a group, by also taking a long-term view on the exposures of the pension schemes within corporate finance decisions.

Recommended actions

Each client will have their own bespoke requirements. However, we see the following four characteristics present in the majority of successful transactions.

  • Forward planning and a robust process are key: The more time available to address break clauses, the greater opportunity exists to identify the optimal solution and execute with the right partners;
  • Understanding the spectrum of outcomes: Establish and challenge internal risk criteria. There are likely to be a range of viable outcomes with different cost-risk relationships, and only by understanding the internal dynamics, including future business objectives, can Boards make fully informed decisions;
  • Optimisation: Utilising the findings and Board decisions to identify efficiencies to allow further improvements / financial savings;
  • Efficient execution: Ensuring that desirable terms can be locked down, which is significantly assisted by demonstrating strong governance, and swift decision making.

How can Centrus assist?

Centrus can:

  • Manage and monitor debt and derivatives portfolios on behalf of clients, and alert them to any upcoming events as well as update clients offering market intelligence and creative thinking regarding value add restructuring options;
  • Provide a balance sheet liability analysis to establish optimal hedging and debt profile;
  • Liaise with the pool of bank counterparties to assess capacity and pricing with a view to analyse efficient use of capital;
  • Work with the treasury function to establish a cost budget and spectrum of objectives for various courses of action for dealing with debt and derivatives restructuring options, such as extension or removal of break clauses, and establish whether the pension scheme may provide for holistic efficiencies;
  • Determine accounting impacts, such as hedge accounting costs for a range of options;
  • Advising on and establishing the process for negotiation of broking transactions, and help identifying a lead broker/arranger;
  • Evaluating opportunities following exercises, and providing advice on execution.