Authored by Andrew Cross

This post will address a question that we have been receiving from many contacts, clients and colleagues in recent days (particularly in light of the rate cut announced yesterday afternoon by the Federal Reserve Board).

**What will happen to an interest rate swap in a zero or negative interest rate environment?**

We first addressed this question in a May 2015 post entitled, Dealing with “Deemed Zero Rates” in Loan Agreements and Related Interest Rate Swap Documentation.

**The Basics of Interest Rate Swap Documentation **

Typically, fixed-for-floating interest rate swaps are structured on the basis of contractual terms and provisions published by the International Swaps and Derivatives Association (“ISDA”) and known as the 2000 ISDA Definitions or the 2006 ISDA Definitions (collectively, the “Definitions”).

The Definitions tend to work in the same general way for most fixed-for-floating swaps. On one or more agreed upon dates, one party (the fixed rate payer) will be required to make a payment to the other party (the floating rate payer) based upon a stated, fixed percentage rate. And, on the same agreed upon date(s), the floating rate payer will be required to make a payment to the fixed rate payer based upon the then-current level of a stated reference rate * plus or minus a spread * (for example, LIBOR or SOFR plus or minus a spread of 25 basis points).

Rather than exchanging payments, the swap documentation would require the party that owes the most to make a net payment to the other party. If the amount of the fixed rate payment exceeds the amount of the floating rate payment, then the fixed rate payer pays the net amount that it owes to the floating rate payer (i.e., the amount by which the fixed rate payment amount exceeds the floating rate payment amount). The opposite is true, if the amount of the floating rate payment exceeds the amount of the fixed rate payment.

**Determining Payments in a Zero or Negative Rate Environment**

The foregoing is a standard description of how a fixed-for-floating interest swap works. It is helpful – and necessary – background to understand what happens to an interest rate swap in a zero or negative interest rate environment.

As an initial matter, it is necessary to identify the particular reference rate specified by the interest rate swap documentation and to keep in mind that it is that rate – and only that rate – that is relevant to an analysis of a particular swap.

If we assume that the relevant reference rate is literally zero, then the next step is to consider whether there is a spread.

- If there is no spread, then the fixed rate payer would owe the fixed payment amount to the floating rate payer. And, the floating rate payer would owe nothing to the fixed rate payer.
- If the spread is
to the zero rate, then the description of the payment flows under the heading,*added***The Basis of Interest Rate Swap Documentation**, would apply. If the fixed payment amount is greater than the floating payment amount (i.e., the spread, since that amount is added to zero), then the fixed rate payer would make a net payment to the floating rate payer. This would be the case, if the spread is less than the fixed rate payment (which would usually be the case). - If the spread is
from the zero rate (a scenario that is unlikely, but at least theoretically possible), then it becomes necessary to consider how the standard interest rate swap documentation addresses a negative floating payment amount.**subtracted**

In short, the Definitions provide two different methods for dealing with a negative floating payment amount. Absent a special election by the counterparties to the swap, the Definitions default to a method by which the fixed rate payer would owe the floating rate payer a payment to account for a negative floating payment amount. This payment would be in addition to the fixed amount owed on the swap. As we explained in our 2015 post, the counterparties to the swap can elect for another method to apply to their swap. Pursuant to this alternate method, if the floating payment amount is negative, then the floating rate amount is deemed to be zero and the fixed rate payer would only be obligated to pay the fixed payment amount owed on the swap.

Thus far, we have only given primary consideration to a “zero rate” environment. But, these two methods apply equally to a negative floating payment amount that is owed in a negative rate environment, such as would be the case if the amount of the negative reference rate exceeds the spread and the spread is added to the reference rate. In theory, this approach would also apply in a positive rate environment, if the spread is greater than the reference rate and subtracted from that reference rate, resulting in a negative floating amount.

**So, what will happen to an interest rate swap in a zero or negative interest rate environment?**

You may have seen this coming, but the short answer is…

…It depends.

**Additional Considerations**

Please see the 2015 post for additional things to consider before making any deemed zero elections. They are important.

Good day. Good to always pay attention to any elections available. DR2