On 27 July 2020, after a five week delay due to the coronavirus, the largest two central counterparties for European interest rate swaps began using the Euro Short Term Rate (€STR) curve to discount and value those swaps. This will impact the value and interest sensitivity of many institutional investors’ swap portfolios. For most investors hedging long term interest rate risk, the value of their swap portfolios are likely to increase. The central counterparties are calculating and applying offsetting compensation amounts so that investors are not unduly advantaged or disadvantaged by these changes.
The €STR curve will replace the European Over-Night Index Average (Eonia) rate curve, which has been in use since after the financial crisis in 2008/09 as a standard proxy for a risk-free interest rate curve. Eonia was deemed to be non-compliant with the EU Benchmarks Regulation, introduced in 2018, and is expected to be phased out by the beginning of 2022. Since October 2019, the Eonia fixing rate has been defined as the €STR fixing rate plus a spread of 0.085%.
Figure 1: Eonia curve versus €STR curve as at 24 July 2020. Source: Bloomberg.
Using a different discounting curve means the value placed on swaps will change. How much they change will depend on the individual swap's contract terms, most importantly their term to maturity and how in- or out-of-the-money they are (i.e. whether they already have a positive or negative value for the investor). The longer the term to maturity, the greater the effect of the discounting switch. Swaps which are far in-the-money will normally increase further in value and, on the flip-side, far out-of-the-money swaps will decrease further in value. For swaps which are close to the money, the effect can be more nuanced, depending on intricacies such as the particular shape of the curve at the time of calculation.
Implications for pension funds and life insurers
For many long-term investors, such as pension funds and life insurers, who hedge long-term interest rate risk, the falling trend in interest rates in recent years and, more recently, since the coronavirus crisis began, will mean most of their swaps are likely to be in-the-money. The effect of the discounting change will therefore be to increase the value of their swap portfolio.
The discounting change is a change to the terms under which swap contracts were entered into. The central counterparties (LCH and Eurex) will therefore have calculated compensation amounts which will be deducted from the accounts of investors who see a rise in value of their swaps. Similarly investors whose swaps fall in value will have compensation added to their accounts. The calculation methodologies for the compensation are very similar for the two counterparties and are based upon swap values as at close of business on Friday 24 July 2020. The way in which the compensation is accounted for will differ, although this will not materially affect the net financial impact for the investor.
One area some investors may need to consider is the interest rate sensitivity of the swaps. Adopting a lower discount rate will make swaps more sensitive to interest rate movements in nominal terms and so may lead to a limited change in the interest rate hedging level. Depending on the precise method by which investors measure their interest rate hedging level and the accuracy and frequency with which it is measured, some adjustment to the swap portfolio may be required. In particular where the interest rate hedging happens to be close to a mandated limit.
In conclusion, the net financial impact of these changes will be limited but we believe institutional investors should be aware of what is happening and understand if there is any action they need to take as a result. For investors with bilateral swaps, where the swap contract is directly with a counterparty bank, we expect formal engagement from the relevant counterparties in due course, following the implementation by the central counterparties.