Potential refinancings of the PPP Debt
Why refinance? Refinancings generally occur because the borrower is able to achieve a lower rate of interest than they currently pay.
Interest payments are split into two components: the base component and the credit spread. The base component is the underlying rate of interest that is paid by high quality borrowers. In the UK for large borrowers, the base component is either Gilts-the fixed rate at which the UK Government borrows-or LIBOR (the London Inter-bank Offered Rate)-the floating rate at which banks borrow from each other. At the time of any debt issuance, Gilts will be quoted at a fixed rate of interest, whereas LIBOR will be floating rate interest for short periods (eg three or six months). Borrowers can enter into interest rate swaps in order to swap payment of LIBOR for payments of fixed rates of interest.
The credit spread is the premium that the borrower must pay for being a riskier investment than either the UK Government or banks and is quoted as basis points15 over Gilts or LIBOR.
A borrower can achieve lower interest rates if either the base component decreases and/or the credit spread decreases.
However, if the base component is at a fixed rate of interest (either Gilts or interest rate swaps) and the borrower wishes to repay the loan in order to refinance, the borrower may be required to pay a prepayment fee to the investor.16 Because the prepayment penalty will be essentially equivalent to any benefit that the borrower could gain from lower interest rates, the effect of fixed interest rates is that a borrower will not be able to achieve any significant benefit from reduced underlying interest rates.
With credit spreads, a borrower will be able to achieve a lower rate of interest without prepayment penalty if the borrower can reduce its credit spread. A borrower's credit spread can go down for several reasons:
(a) improved credit and therefore becoming a less risky investment,
(b) market reductions in credit spreads at that level, and
(c) structural enhancements to the debt which reduce its riskiness (although the borrower itself does not become less risky).
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15 1 basis point % 0.01%.
16 The prepayment fee is paid in order to " make the investor whole " for the returns that the investor will not be earning due to the prepayment. It is calculated by comparing the interest rate on the bond or interest rate swap currently in place against the current base interest rates at the time of refinancing. If interest rates at the time of refinancing are lower than the existing bond or swap, the borrower will need to make a payment to the lender. With interest rate swaps for bank loans, if interest rates at the time of the refinancing are higher, the bank will make a payment to the borrower. With bonds, if interest rates at the time of refinancing are higher, no additional payments from either party will be made.