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The lowdown on swap rates – explainer

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  • 19/05/2022
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The lowdown on swap rates – explainer
Swap rates have been rising dramatically over the past few months due to market expectations around rising interest rates, fuelled by economic uncertainty, and culminating in a rising mortgage rates.

Mortgage Solutions has spoken to several commentators about what swap rates are, why they are rising, what the outlook is, why they’re so important, and what brokers can do to help their clients.

 

What are swap rates?

Swap rates are an agreement between two parties where they agree to exchange one stream of future interest payments for another, based on a specified principal amount. They are used by mortgage lenders to mitigate the interest rate risk in a fixed rate mortgage.

One party agrees to receive a fixed-rate payment, while the other receives a variable payment.

Alex Maddox, head of capital markets at Kensington Mortgages, defines it as the rate a mortgage lender must pay in order to mitigate the interest rate risk in a fixed rate mortgage.

 

Current swap rate comparison

According to Chatham Financial, the current two-year Sterling Overnight Interbank Average Rate (SONIA) swap rate is 2.15 per cent, while a five-year equivalent sits at 2.03 per cent. The 10-year swap rate is priced at 1.85 per cent.

This is very high compared to 18 May 2021, where the two-year swap rate was 0.13 per cent, a five-year swap rate was 0.47 per cent and a 10-year swap rate was 0.83 per cent.

Mark Harris, chief executive at SPF Private Clients, said: “Lenders are essentially hedging their bets against what could happen to interest rates over various periods, and are an indicator of interest rate expectations.

“As swaps increase, fixed rate mortgages typically rise in price and in doing so, impact affordability negatively. Conversely, if swaps fall, fixed rate mortgages typically follow suit and the affordability and borrowing potential is positively impacted.”

He added that swap rates have been rising since the negative swaps were observed at the end of 2020.

However, he said that there had been a “rapid acceleration” since the last quarter of 2021, which has seen costs double.

“That has been reflected in the rising cost of mortgages, along with lenders’ desire to balance volume and service,” he added.

Jeremy Duncombe, managing director of Accord Mortgages, said swap rate pricing has been moving very quickly, adding that he has seen a 0.2 per cent rise in swaps in one day, which was previously very rare.

“When lenders price products, what we’ll do is buy a tranche of money at a certain rate and then we lend it out at a rate plus a margin. As you would imagine, if those rates are changing very quickly, fixed rate pricing needs to change too.”

 

Why are they increasing?

Swap rates are based off market assumptions surrounding what interest rates will be over the term of the swap rate, the calculation of which involves a number of factors.

The market currently expects interest rates to be higher in the next two years, and then taper off slightly after five years.

Duncombe said: “They’re all based off current assumptions, so factors like inflation, the conflict in Ukraine, prices, fuel, gas prices and the general economy, will feed into where those forecasts come from.”

Interest rates have been increasing in efforts to curb inflation, with the Bank of England raising the base rate to one per cent in early May.

This is now the fourth increase from the historically low rate of 0.1 per cent in December 2021. It then rose to 0.25 per cent before climbing to 0.5 per cent in February and leaping to 0.75 per cent in March 2022.

Further interest rate rises are expected. Maddox predicts that rising inflation, which recently hit nine per cent, would lead to steeper rate rises in the near future.

However, market consensus is that interest rate rises will slow in the longer-term, leading to short-term swaps becoming more expensive, which then feeds through into consumer pricing.

Harris said: “‘Currently, shorter-term swaps are more expensive than longer-term equivalents. This inverted view has led to longer-term mortgage products, such as five-year fixes, being priced at a lower rate than the two-year equivalents.

“This is an indication that the financial markets predict greater risk over the next few years and a more settled outlook in five to 10 years’ time.”

 

Will this continue?

There is still a large amount of uncertainty in the market, with inflation expected to continue rising while the ramifications of the ongoing conflict in Ukraine are still to be seen.

Maddox said: “Swap rates are broadly expected to increase a little then stabilise, but the market is very volatile and so that expectation could change materially.”

Duncombe added: “I think it’s likely to continue to be volatile because there’s so much going on in the wider world that we can’t control.”

“If you go back through the last 10 years or more, we had a really stable base rate for years where base rate was half a per cent, or quarter per cent, but fixed rates moved around quite significantly because of market sentiment. The fixed rate pricing in particular is affected by market sentiment and anticipation.”

What can brokers do?

Brokers should engage with clients early so that they can make informed decisions around their product choice and keep themselves as up to date as possible.

Harris said: “Advisers should be on the front foot to engage with clients. Sadly, the lowest, sub-one per cent rates seen in the fourth quarter of last year are long gone, but even so, rates are still historically low.

“Also, there can be a disconnect between mortgage rates and swaps as lenders strive for volume and greater competition, typically leading to lower rates.”

He added that understanding the “client’s needs, wants, motivations and concerns” would help advisers make the “most suitable recommendation”.

Duncombe believes brokers should explain to their customers that “external factors affect fixed rates more than the base rate”, and have a conversation around how this works.

He added: “There’s an opportunity for brokers to reach out to clients to make sure customers are comfortable with their expenditure, and their affordability.

“As lenders, we all stress mortgage payments based on much higher rates, but it is worth checking with clients – even if they are locked in for two or five years – to reassure them and make sure they’re comfortable with what happens at the end of the fixed rate period.”

He continued that it was a good customer retention strategy for brokers to talk to new and existing clients to “reassure and advise them, so that they know you are there for them, whatever their circumstances”.

Merrett said it was crucial for brokers to educate themselves as much as possible, by reading the trade press, news, blogs, talking to lenders and attending distributor events to familiarise themselves with the economic landscape.

“Although you are really busy and under pressure, spend some time familiarising yourself with how it works because the greater the context you have, the more clarity and the better advice you can give. We’ve seen the proportion of people using advisers for mortgages go up again, during and after Covid, so the role of the broker is more important than ever,” he added.

Merrett continued that brokers have a “duty of care to the consumers to be able to equip them with enough information to help them make informed decisions”.

“There isn’t a broad brushstroke of ‘this is right, this is wrong’, but now more than ever there is overwhelming [evidence that] long-term longer term fixed rates are sensible.”

He said proactive contact with clients, especially those remortgaging, was very important.

“If you’re not getting in touch around six months in advance, which is the typical mortgage offer validity, then you are potentially putting your customer at risk,” he said.

 

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