Of Swaps & Spreads: Why the Swap Rate Matters for Fixed Rate Mortgages
Understanding the intricacies and drivers of mortgage pricing is crucial for mortgage advisors. Fixed rate mortgages make up the majority of mortgage lending in the UK and the headline rate comprises two elements, the swap rate at the relevant maturity (e.g. the 2 or 5 year SONIA rate) and the “spread” (the margin) over this swap rate, set by the lender.
Headline fixed rate = Swap rate + Spread
In this series of blog articles, we look at why the swap rate is relevant for banks, drivers of the swap rate, and drivers of the spread.
Here we look at why the swap rate is important for fixed rate mortgages. See our other article on drivers of mortgage spreads.
Interest rate behaviour: Fixed or Floating
Floating or behaviourally floating interest rates are rates which move with market interest rates, such as the Bank of England base rate. Floating rates move automatically, while behaviourally floating rates are not contractually obliged to move, but usually do.
Fixed interest rates are rates which do not move with bank rate (usually for a certain time period).
The Mismatch in Banks Balance Sheets with Fixed Rate Mortgages
A retail bank's business model is fundamentally to loan money to borrowers at a higher rate than it pays to depositors.
Net Interest Income = Interest earned on Assets (Loans) – Interest paid on Liabilities (Deposits)
However, this dynamic is complicated when the interest rate sensitivity of the asset and liability side is different.
Liabilities (Deposit) Interest Rate Behaviour: The majority of large banks in the UK are funded by deposits, which typically pay a rate below the prevailing bank rate and behaviourally move with bank rate. That is, when bank rate goes up or down, lenders “pass-through” a certain proportion of this bank rate change to depositors.
Asset (Loan) Interest Rate Behaviour: On the asset side of the balance sheet banks make loans, which can be either fixed or floating interest rate. There has been a trend in the UK to fixed rate mortgages.
If banks do not use swaps to address the floating-fixed mismatch, then they are taking interest rate risk. The Prudential Regulation Authority (the UK bank regulator) monitors the interest rate risk that banks are taking, and intervenes when banks are taking interest rate risk.
A simplified example of fixed rate mortgages without swaps
Say a bank (Bank A) has a portfolio of £100m fixed rate mortgages paying a 2% rate, and pays £100m of depositors 0.4%, with bank rate at 0.5%. They receive 2% from borrowers and pay 0.4% to depositors, so make positive Net Interest Income.
Now say there is a bank rate rise to 4%. If other banks now pay depositors 3.5% on savings, Bank A needs to also raise its deposit rate or it risks deposit outflows. Bank A raises its deposit rate to 3.5%; however, it is only receiving 2% from its mortgage portfolio. It then incurs losses at the net interest income level, before even taking into account other expenses!
Conversely, if the interest rate went down, banks would make higher profits due to its higher fixed rate mortgages. However, the regulator does not want banks to be interest rate speculators!
Understanding interest rate swaps
A swap is an instrument used to transfer interest rate risk and has two legs, a floating leg and a fixed leg.
One counterparty pays the floating leg and agrees to pay the other party the prevailing floating rate (e.g. SONIA) for the life of the swap (e.g. 2 years) and it receives the fixed rate in return.
Conversely, the other party pays a fixed rate, known as the 'swap rate', for the life of the swap and receives the floating leg (e.g. SONIA or the bank rate).
Banks pay the fixed leg and receive the floating leg when engaging in swaps for the purpose of mortgage lending.
A simplified example of fixed rate mortgages with swaps
Let’s say bank rate is 0.5%. Bank A has £100m of deposits, which it currently pays 0.4%.
Bank A wants to write £100m of 2-year fixed mortgages at a 2% headline rate. The 2-year Swap Rate is 0.8%. Bank A agrees to pay the swap rate over the next 2 years to the swap counterparty, in return for a floating rate (e.g. whatever the prevailing bank rate is). The spread is then 1.2% (the 2% headline rate minus the 0.8% swap rate).
The bank then receives the floating rate (bank rate) + a fixed spread (1.2%) on its mortgage portfolio, and the interest rate behaviour of the asset side now matches that of the liability side.
Now let’s say (as before) bank rate increases to 4% and other banks pay depositors 3.5%. The bank would continue to receive a spread of 1.2%, pay out 0.8% to the swap counterparty, and now receive the higher floating rate of 4%. As a result, the bank could pay its depositors 3.5% while still maintaining a positive net interest income.
Therefore, even though the bank is receiving a fixed rate from borrowers and paying a floating rate to depositors, through interest rate swaps it is not taking any interest rate risk!
This explains why the swap rate is so crucial for headline fixed mortgage rates in the UK.
Have any questions or want to discuss the above? Drop us an email at info@keychain.co.uk.
About Keychain
Keychain is an all-encompassing client portal tailored for mortgage and protection advisers. It enhances client and adviser interactions by offering digital fact-finding, secure document sharing, e-signatures, and automated reminders. Book a demo of the platform here.
About us
Pricing
FAQs
Contact us
Blog
Keychain is the registered trademark of IJSR 7 Ltd, company number: 13687896.