Treasury Rate Lock Agreement Author: Financial-edu.com
A Treasury Rate Lock Agreement (RLA), commonly called a Rate Lock, is a contract used by a bond issuer to fix its future bond issuance yield or rate.
Corporate bonds are issued by borrowers based on a spread over U.S. Treasury Bond yields. For example, a bond issuer plans to borrow $100 million, with the bond issuance date anticipated to be in 60 days, and the bond issue yield priced 150 basis points over 10 year U.S. Treasury yields in effect on the date of issuance.
Bond issuers are exposed to two possible risks: 1) U.S. Treasury yields will rise (prices drop), or 2) the basis points spread over U.S. Treasury yields expected by the market will change. Furthermore, the bond issuer may not know the exact issuance date until the final days before issuance due to registration, documentation, due diligence, or market reasons.
One solution is for the bond issuer to buy a Treasury Rate Lock Agreement (RLA) from a bank counterparty. The RLA “locks in” current Treasury yields for the future bond issue. If the issuer believes yields today are favorable and does not want to run the risk that future yields (and therefore cost of borrowing) will rise, an RLA will hedge the risk of rising yield. An RLA can be created on any yield-based instrument or index.
“Rate” Lock versus “Yield” Lock
Treasury yields move both as a result of prevailing interest rates (determined by government central banking authorities) and bond prices (determined by the supply and demand for bonds at a given coupon rate). A true “yield” RLA locks in a forward yield, such as 10Y U.S. Treasury yield. A “yield” RLA locks in the relationship between a Treasury bond’s price and the bond’s coupon rate. An issuer can then hedge its actual “real” cost of borrowing if it needs to discount the bond price at issuance to attract investors at the bond’s coupon rate. A “yield” RLA does not require the issuer to take a position on whether yields will be driven by interest rates or Treasury bond price changes. Instead, it allows the issuer to hedge underlying Treasury yields while leaving the bond issue price and coupon rate free to move.
A “rate” RLA locks in a forward rate only. This contract is akin to a Forward Rate Agreement (FRA) because it only locks in a forward rate. A “rate” RLA does not hedge Treasury bond yields, and is therefore an imperfect hedge for a future bond issuance. A “rate” RLA would be used if the issuer was primarily concerned with interest rates rising because it plans to issue the bonds at par by manipulating the coupon rate to make the bonds more or less attractive to investors.
Costs, Benefits and Risks of Rate Locks
The costs of entering into an RLA are: a) a premium paid to the RLA seller in the form of a spread above current yields, and b) the inability to take advantage of future rate decreases.
One of the key benefits of an RLA is that no cash exchange is required up front. RLAs are unfunded instruments that allow the counterparties to enter into a contract without significant transaction costs. Because no cash is required up front, RLAs also offer potentially high leverage.
There are several risks associated with an RLA.
An RLA does not insulate a corporate bond issuer from a change in spreads over U.S. Treasury yields (basis risk). Basis risk is industry- and company-specific, and must be hedged separately with a spread lock agreement.
An RLA requires the issuer to make a bond issuance by a specific date, with a specific par amount, and a specific amortization schedule. Thus, RLAs are not options like interest rate caps or floors. They are obligations to do something specific in the future. To offset the potential risk of not being able to issue bonds within these constraints, RLAs are often structured with a call feature that allows the issuer to settle and cancel the remainder of the RLA prior to expiration. In most cases an issuer will require the expiration of the RLA to fall beyond the anticipated bond issuance date to offset the inability to exactly time the bond issue. With a call feature, bonds can be issued a few days or weeks prior to the RLA expiration, and the issuer can call the RLA early to close out the deal. If the bond issuance date goes past the RLA expiration, the counterparties can simply amend the agreement to take into account the new date and may change the terms to accommodate any market changes.
Since RLAs are OTC contracts, they have counterparty risk. However, Treasury Rate Lock Agreements priced against U.S. Treasury yields are fairly liquid, which mitigates some of the counterparty risk.
Uses for Rate Locks
RLAs can be used for many purposes, including:
• Future public debt issues by governments or municipalities
• Hedging the future sale of fixed rate receivables
• Pre-circle private placement rates
• Pre-circle rates on term fixed bank rate loans
• Hedging pipeline risk from securitization programs
• Future lease agreements
• Bond tenders (buybacks of outstanding bonds by the issuer)
• Early termination of private placements (buybacks of outstanding private placement bonds by the issuer subject to make-whole provisions that require the issuer to pay more to buy back the bonds if Treasury rates drop)
• Debt defeasances
• Investment in fixed income assets
• Pension benefit plan changes (e.g. a company decides to terminate its pension plan and purchase annuities for plan participants as a substitute, where a decline in Treasury rates will cause an increase in the purchase price of annuities.)
In several of the above situations, the benefit associated with the RLA is the hedge against an increase in future rates, while in others the benefit is the hedge against a decrease in future rates.
Rate Lock Models
“Rate” Model -- Forward Rate Agreement (FRA)
o Rate based
o Cash settlement at expiration
o No cash up front
o Requires: 1) lock rate, 2) treasury curve, 3) 3M LIBOR discount curve
o Setup: Use lock rate as FRA rate, otherwise standard FRA setup
“Yield” Model -- Synthetic Treasury bond
o Yield based
o Problem with finding a Treasury bond with equivalent start and end dates as the RLA period.
o Requires: 1) lock yield, 2) treasury curve, 3) 3M LIBOR discount curve
o Setup: Short Treasury bond position with cash settlement specified in the term sheet.
o Variation: Possible call feature with the issuer able to call the RLA and cash settle prior to expiration.
Other possible models:
Exotic formula setup:
o Yield based (problem – calculating yield from prices, calculating appropriate PV01’s without existing bond prices & using substitute bond(s))
o Cash settlement: Requires: 1) lock yield, 2) treasury curve, 3) PV01 curve externally generated and imported, 4) yield calculation formula, 5) discount curve
o IR caps and/or floors (for “Rate” RLA)
o Treasury yield options (for “Yield” RLA)
o Treasury yield futures (for “Yield” RLA)
Rate Lock Formulas:
Payment due from Issuer (borrower) to Writer (lender/bank) = PV01 x (lock rate – treas. rate) x notional
Payment due from Writer (lender/bank) to Issuer (borrower) = PV01 x (treas. rate – lock rate) x notional
• All trades are set up from the perspective of the bank/dealer/seller (sell side).
• Rate lock period is 1-3 months (equivalent to bond issuance date some time in the next 3 months).
• Trade start date is in the future
• Trade end date is 3 months from start date
• 3M LIBOR curve is used for discounting: USD LIBOR
• US Treasury curve is used for pricing flows: USD TREAS
• Lock rate is specified (e.g. 5.06%)
SETUP #1: “Rate” RLA -- Forward Rate Agreement (FRA)
A Forward Rate Agreement is an agreement today to lock in a forward interest rate sometime in the future. For example, a bank who sells a 3x3 FRA to a bond issuer at 5.06% agrees to pay the issuer if the 3 month forward rate 3 months from now is above 5.06%, and the issuer will have to pay the bank if the 3x3 rate is below 5.06%. The bank profits by selling a FRA with a lock rate higher than the current forward rate and taking this spread times the total notional. A FRA is similar to an RLA in the fact that no cash changes hands at the inception of the contract and payment is made on expiration.
However, there are two key differences between a FRA and an RLA: 1) FRAs lock in a rate, whereas “true” RLAs lock in a yield (a function of both price and rate), and 2) FRAs are typically on short term interest periods like 3M LIBOR, whereas RLAs are typically on long term periods like 10Y U.S. Treasury yields. A FRA setup only works if the RLA locks in a specified rate, not a yield. A bond issuer would purchase a FRA if it believed that interest rates were likely to rise in the period leading up to the bond issue. A bond issuer would also use a FRA if its bond issuance was to be priced at a spread over a base rate such as 3M USD LIBOR, rather than at a spread over a base yield such as Treasury. To get this FRA to price like a 5Y “rate” RLA, you need to set up a 3x60 FRA on the Treasury rate. This is a forward-starting contract on a forward rate, so it will start 3 months in the future.
A FRA can be combined with a spread lock to more fully hedge the issuer's risk that corporate spreads over Treasury yields will move unfavorably before the bond issuance date.
Setup #2: “Yield” RLA -- Synthetic Long Treasury Bond
From the bank’s perspective, selling a “yield” RLA is equivalent to taking a long position on Treasury bond price. When a bank sells a “yield” RLA to an issuer, it must pay the issuer if yields rise (bond prices fall) and will receive payment if yields fall (bond prices rise). The bank profits by selling an RLA with lock yield higher than the current forward yield and taking this spread times the total notional.
There are several problems with booking a long Treasury bond position as a “yield” RLA: 1) finding a bond with equivalent dates as the RLA period, 2) simulating the initial long bond position without the required physical purchase and delivery of cash at inception, and 3) simulating the physical delivery of a bond at expiration with a cash only payment.
To set up a long Treasury bond position that matches the RLA terms, first try to identify a Treasury bond with a similar expiration date equal to the time period until the forward rate lock fixing (the RLA expiration date) plus the issuer’s intended bond tenor. Here, our RLA expires in 3 months, and the Issuer’s bond will be a 5Y bond (60 months), so the target Treasury bond expiration date would be today plus 63 months. Next, set up the synthetic long forward Treasury bond trade. In order to book this trade properly, you must specify cash settlement and no physical delivery of the bond either at the start or end of the trade. It is not necessary for the bond to actually exist in the hands of either the bank or the issuer.
Hedging Rate Lock Trades
Hedging Setup #1 - FRA
Any interest rate instrument can be used to hedge a FRA, including a long cap, Treasury futures, Treasury swap, etc.
Hedging Setup #2 - Synthetic Bond
To effectively hedge a synthetic long bond position, the bank can buy a “yield” RLA from another bank, or sell Treasury bonds short. Both positions are equivalent to shorting treasury prices and will profit if yields rise. By pairing the RLA position with an opposite “yield” RLA or a short Treasury position, the bank can profit from the spread between the RLA lock yield and current implied forward Treasury yields.
There are two problems with using a short Treasury bond position to hedge a “yield” RLA: 1) finding a bond with equivalent dates as the RLA period, and 2) the requirement for physical delivery in a short sale of a bond is different than the cash delivery of the RLA.
To set up a Treasury bond short sale that matches the RLA terms, first try to identify a Treasury bond with a similar expiration date equal to the time period until the forward rate lock fixing (the RLA expiration date) plus the issuer’s intended bond tenor. Here, our RLA expires in 3 months, and the Issuer’s bond will be a 5Y bond (60 months), so the target Treasury bond expiration date would be today plus 63 months. Next, set up the short forward Treasury bond trade. Here, it is not necessary to specify cash settlement, because this is an actual short bond position with a counterparty other than the issuer who bought the “yield” RLA.