As you may have seen in the news today the Bank of England (which is independent of the Government) announced an emergency in cut in the Base Rate by 50BPS to 0.25%. This level hasn’t been seen in the UK since the Global Financial Crisis 12 years ago.
What does this mean? If a company is borrowing on a variable rate, they will benefit from this cut straight away in terms of reduced interest payments (though the margin will remain the same). But if the business is on a fixed rate they will not (using a swap), unless they have some sort of hedge in place that allows a benefit (such as an interest rate cap).
However, if a company is borrowing on Libor (of another index) they may not see the same benefits, though the same points about fixed rates/swaps/caps apply. Today the Base Rate id 0.25% in the UK, but the 3 Month Libor rate (the usual benchmark) is trading at 0.47%, so a difference of 22BPS. To put this in perspective Base Rate has reduced by 66.7% over the last 5 days and 3 Month Libor by 21.5% – a difference of 45.2BPS (0.452%). This dislocation between Base Rate and Libor is known as interest rate dislocation and gives rise to Basis Risk.
Basis Risk is where you are borrowing on one index and have exposure in another. For example, let’s say you are borrowing on Libor and all your competitors borrow on Base Rate – your funding is more expensive. Or you Borrow on Base Rate but your hedging is Libor based (as it usually is) the cash flows will no longer match.
Usually Base Rate and Libor are within a small margin (2-3BPS) and over time they should balance out, but where you have interest rate dislocation basis risk can be a real problem for borrowers.
A final thought, longer-term rates are cheaper than short term rates – this could also impact borrowing decisions.