Fixing the Cost of a SONIA-Linked Loan
Ridgeway Logistics has a £150m four-year term loan priced at compounded SONIA plus 1.10%, reset annually. The treasurer expects rates to rise and wants certainty. A bank quotes a four-year fixed-for-floating interest rate swap at 3.85% fixed against annual compounded SONIA, notional £150m, with a CSA threshold of £5m and daily variation margining. The bank's mid-market rate is 3.80%, so the quote includes a 5bp dealer spread. Ridgeway is a non-financial corporate; its treasury policy permits swaps up to £200m notional but limits uncollateralised counterparty exposure to £10m. The treasurer's base case is average SONIA of 3.00%, but a stress case is 5.25%. The CFO asks what the swap fixes the all-in cost at, whether it is better than doing nothing, and what happens if rates move sharply in either direction.
1. Calculate the all-in fixed funding cost with the swap, the break-even SONIA rate, and the annual cost with and without the swap in the base and stress cases.
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With the swap, Ridgeway pays fixed 3.85% and still pays the loan spread of 1.10%, so all-in fixed cost = 4.95%. Without the swap, cost = SONIA + 1.10%. Break-even SONIA is where SONIA + 1.10% = 4.95%, so SONIA = 3.85%. Base case SONIA 3.00%: no swap = 4.10%; with swap = 4.95%; swap costs extra 0.85% × £150m = £1.275m per year. Stress case SONIA 5.25%: no swap = 6.35%; with swap = 4.95%; swap saves 1.40% × £150m = £2.10m per year. The 5bp dealer spread is 0.05% × £150m = £75,000 per year, already inside the 3.85% quote. The swap is insurance: it costs money in the base case and pays off in the stress case.
2. Assess the counterparty credit and collateral implications if rates move sharply. Does the CSA threshold fit the treasury policy?
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If SONIA rises, the fixed-rate payer swap becomes an asset to Ridgeway because it receives floating and pays fixed. The bank owes Ridgeway, so Ridgeway has credit exposure to the bank. A rough duration-based estimate: a 1% parallel rise in swap rates on a four-year swap with duration near 3.7 years changes value by about 3.7% × £150m = £5.55m; a 2% rise gives about £11.1m. The CSA threshold is £5m, so the bank posts collateral only above £5m; Ridgeway still carries up to £5m of uncollateralised exposure, which is inside its £10m policy limit. But if the bank fails to post collateral or the CSA is unenforceable, exposure can exceed the limit. If rates fall, the swap becomes a liability to Ridgeway and it must post collateral, creating liquidity risk. The policy permits the notional, but treasury must monitor exposure daily, confirm collateral eligibility and legal enforceability, and stress the cash calls.
3. Recommend whether to execute the full £150m swap, a partial hedge, or an option-based alternative.
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A full £150m swap locks the all-in cost at 4.95% and protects the stress case, but it also locks out the base case and any fall in rates. Given the base case is 3.00% SONIA, the full swap is expensive insurance: it costs £1.275m per year relative to doing nothing in the base case. A partial hedge, for example £75m notional, halves the certainty benefit and the opportunity cost. An option-based alternative such as a cap or swaption would retain downside participation but usually requires an upfront premium and may be less liquid. Recommendation: if the treasurer's primary duty is budget certainty and the stress case would threaten covenants, execute the full swap but document the cost of certainty and monitor the CSA. If the base case is more likely and the company can tolerate some variability, hedge 50–75% and use the remaining floating exposure to retain downside. The 5bp spread is reasonable but should be compared with at least one other dealer.