What are Swap rates and why do they impact Buy-to-Let rates?
How Buy-to-Let lenders are funded
Most Buy-to-Let lenders get their funding through facilities with global financial institutions, which range from investment banks to high street banks, and pension funds to credit funds.
When these facilities are arranged, the financial institution expects a return derived from 2 components, (1) a fixed margin, to compensate them for the risk they’re taking and (2) a risk-free floating rate, such as SONIA, (Sterling Overnight Index Average), which has mostly replaced LIBOR.
Expected Return = Fixed Margin + Floating Rate
The Lender will arrive at the price of their mortgage products using both of these components, but since the floating rate can change during the facilities’ life, the pricing of the products will need to be changed in order to protect returns/margin.
Swap rates and SONIA
The SONIA interest rate exists as a benchmark to provide the best indication of an almost risk-free interest rate, similar to that of the Bank of England’s (BoE) Base Rate or GILTs, and forms the variable or floating element of an interest swap rate, an agreement between two parties where one agrees to exchange their variable interest-rate cashflows for fixed ones.
This SONIA rate is informed by a number of economic and credit factors, but also by the probability that the lending bank will be repaid the next day, therefore it is a rate set on a daily basis.
Almost all non-bank Buy-to-Let lenders’ are required by their funders to enter into these swaps to lock in a price on the floating rate element for the lender, which is the swap rate at the point the swap is entered into.
The reason for this is to protect the lender from an unexpected rise in the floating rate element, of the expected return paid to the funder, causing financial difficulties for the lender and ultimately the funder.
What happens in times of uncertainty
Swap rates take their guide from a number of macroeconomic factors, including but not limited to, inflation and the Bank of England Base Rate. When they move, it creates a risky situation for lenders, here’s an example:
A lender has a 5% product. The expected return to the funder is a fixed margin of 2.5% plus the floating rate of SONIA. At the time the product is released the SONIA rate is 2%. This makes the cost to the lender 4.5% of rate, with 0.5% wiggle room for its costs. If the SONIA goes up to 3%, and drives the swap rates up, this means the lender is making a loss on that product, which it can’t afford to do.
This is why lenders are often repricing a lot and at short notice, as the volatility in the swap rates informs their products and can push them into a place where they aren’t offering sustainable loans to brokers and their clients.