Borrowing in foreign currencies is not for everyone, but the rewards can be significant if clients enter into transactions with their eyes open, Andrew Arnott of Investec's Private Client Lending explains.
When the U5 Federal Reserve (Fed) rate fell to 1% in June 2003, many were quick to take out US dollar mortgages on UK properties in pursuit of a lower cost of borrowing. However, with the Fed rate now at 5.25% - 50 points higher than the UK base rate - this could be a costly decision. Many of those seemingly attractive deals came with 2% margins over Libor and significant early repayment penalties effectively locking borrowers in for long periods.
Anyone considering a currency loan should therefore be aware that interest rates may not stay below UK rates for the term of the loan. The other main risk is that currency fluctuations could increase the sterling equivalent of both the debt and interest payments.
Despite the risks, there are considerable potential rewards. Investec's Private Client Lending team has recently seen a significant rise in demand for loans held in Swiss francs or Euros, driven once again by the low cost of borrowing.
For example, at the time of writing, the three-month Swiss Libor and Euro lnterbank Offer Rate (Euribor) were 1.53% and 3.12% respectively.
We take the view that clients with significant wealth should be able to experience the cash flow benefits of borrowing in foreign currency, as long as they fully understand the risks involved and can tolerate the potential downside.
We do not lock clients in with early repayment penalties and each loan has a predetermined conversion limit (the point at which a loan would be converted back into sterling to limit further exposure to adverse currency fluctuations).
Switchable multi-currency loans may be an attractive alternative to single currency loans for more financially sophisticated clients. We offer a multicurrency lending facility that can be secured against a range of assets, including residential and commercial property. The loan can be switched between different currencies with the objective of reducing the size of the debt and lowering interest costs.
Available currencies include sterling, US dollars, Swiss francs, Euros and Japanese yen. The main principle of multi-currency lending is that the debt can be reduced by switching into currencies that are depreciating against sterling. For example, a £1m loan converted into Euros at 1.40 gives a € l.4m loan. If the pound strengthens to €1.60, when converted back into sterling, the loan has been reduced to £875,000.
At Investec, clients with experience in foreign exchange markets may opt to manage their loan currency switches themselves, while those without trading experience can appoint a specialist currency debt manager such as The ECU Group plc to do it for them. The ECU Group has been managing currency debt since 1988 and their performance has been impressive. For example, over the last three years, a multi-currency loan in the ECU programme would have seen a total debt reduction of 16.5% - that is without a single capital repayment being made. The average interest rate over the same period (assuming a rate of 1.75% over Libor) was 3.14%.
These features make a managed multicurrency facility particularly attractive to individuals with long-term, interest-only sterling loans secured on residential or commercial property with around 30% to 40% equity. When a currency manager is successful, this can improve cash flow and reduce the debt on an interest-only loan.
Clients who require access to our currency mortgage capabilities should have annual incomes of more than £150 000, a minimum borrowing requirement of £500,000 and the resources to absorb adverse currency fluctuations.
Currency loans are a relatively high-risk strategy and therefore not appropriate for risk-averse individuals. However, for clients with an appetite for some risk, multi-currency lending is a compelling alternative to traditional sterling mortgages.
Trading in foreign currencies is not suitable for everyone and a client must ensure that they fully understand the risks involved before proceeding. A client should consult their financial adviser if they have any doubts about their suitability or the risks involved. Foreign exchange movements can be sudden and substantial. At no stage should a client expose themselves to the high risks of foreign currency trading if they are not able to afford the potential losses that could result from sizeable adverse currency movements. Past performance is not a reliable indicator of future performance.
Please note that for compliance purposes telephone calls may be recorded.
Specific additional risks for our currency management products are as follows:
Private client multi-currency mortgages
a) At no stage should a client be exposed to the high risks of foreign currency borrowings if they are unable to afford the potential losses that could result from adverse currency movements and the higher interest costs that would arise from having a larger loan.
b) A client’s lender will not tolerate an increase in the GBP value of a client’s loan above a predetermined level as a result of currency losses. The lender will agree a “Conversion Limit” with the client before a client takes out an ECU managed multi-currency loan. If the loan reaches or breaches its “Conversion Limit”, the lender may exercise its right, but not its obligation, to convert the loan back into GBP. However, a loan may be converted back into GBP at a worse level than the agreed Conversion Limit. This would mean that a client’s loan would increase by more than it would if it had been converted at the agreed Conversion Limit. Converting a loan back into GBP may result in a permanent increase in the GBP value of a client’s loan and the associated GBP interest costs.
c) The FSA risk warning is “Your home may be repossessed if you do not keep up repayments on a mortgage”.
Corporate loan management
a) At no stage should a client be exposed to the high risks of foreign currency borrowings if they are unable to afford the potential losses that could result from adverse currency movements and the higher interest costs that would arise from having a larger loan.
b) A client should be aware that their lender may not tolerate an increase in the base currency value of a loan if it exceeds a certain level and will have the right to convert the loan back into the base-currency.
Managed FX accounts
a) A Managed FX account is a margin account which is not suitable for everyone. A client must ensure that they fully understand the additional risks involved in margin trading.
b) A client should be aware that their lender will require additional margin to be paid on demand and will have the right to close any open positions if this additional margin is not promptly paid.
c) As with all margined products it is possible to incur significant losses and to lose more than the margin in the account at any one time.
The UK Regulatory System
The ECU Group plc ("ECU") is authorised and regulated by the Financial Services Authority.
In respect of managing physical liabilities in foreign currencies, ECU trades the foreign exchange markets on a spot basis and issues switch instructions to lending banks on a spot basis. Neither of these activities is currently regulated by the Financial Services & Markets Act 2000 as they meet the "Commercial Purposes" test. Therefore you will not benefit from the protection of the Financial Services and Markets Act 2000.
However, if ECU instructs the Lender, or any prime broker or counterparty with whom ECU effects foreign exchange transactions, to conduct a switch by way of effecting an “option” or “futures” transaction for the Client’s account, such transactions may be considered to be an “investment of a specified kind” under the Financial Services and Markets Act 2000. Consequently, both the execution process provided by the Lender, or any prime broker or counterparty with whom ECU effects foreign exchange transactions, and the currency management services provided by ECU, as envisaged under this Agreement, may be considered to be regulated activities. In such instances, the Client may be required to sign additional risk warnings and the rules for the protection of investors under the Financial Services and Markets Act 2000 will apply.
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Borrowing in foreign currencies is not for everyone, but the rewards can be significant if clients enter into transactions with their eyes open, Andrew Arnott of Investec's Private Client Lending explains.
