Predicting Future Interest Rates
Rates will be going up and vulnerable business owners should get prepared.
Interest rates are nearly as low as they can be, as illustrated in the chart on
the following page. The Federal Reserve has signaled that it will attempt to quickly
withdraw liquidity from the credit market at the first sign of inflation. The question
does not seem to be whether or not rates will rise, but rather when and by how much.
Users of senior debt have enjoyed nirvana since 2000. With the support of the Fed's
efforts to drive down rates, businesses have funded the expansion of long-term assets
with variable-rate debt, in the predominately floating-rate bank market. Staying
at the short end of the curve has been a winning strategy and made interest rate
risk management a less important endeavor. As a consequence, the focus has been
on credit spread, rather than the long-term, all-in cost.
However, the interest rate risk currently being borne by businesses is potentially
catastrophic. Whereas companies have been hit hard on the revenue line since 2007,
interest-rate movements could increase credit expense several fold. The double-whammy
of eroding EBITDA and higher debt service obligations could create a difficult set
of hurdles for borrowers with above-average leverage. It is incumbent upon business
managers to take seriously the job of insuring against that outcome.
As illustrated in the nearby yield curve chart, one-month Libor has declined 500
basis points since the eve of the financial crisis in June of 2007. At 32 basis
points, as of April 15th, there is little room to move lower.
In addition, the shape of the yield curve has changed markedly in the last 30 months
as short-term rates have fallen relative to long-term rates. The gap between one-month
Libor and the 10-year swap rate now exceeds 380 basis points. This is compared to
a 44 basis point differential in 2007.
FUTURE INTEREST RATES
The "$64,000" question is, how long will rates remain at these levels? We are certainly
not in the business of predicting interest rates, regardless of this article's title,
but the current slope of the yield curve is generally indicative of an expectation
of rising rates as we look out beyond 2010. If business owners have learned anything
over the past three years, it should be that change can occur rapidly, often unpredictably.
INTEREST RATE RISK MANAGEMENT
Knowing that it makes sense to hedge against rising interest rates is one thing.
Implementing the optimal strategy is another. In our view, interest rate risk mitigation
should be approached from the insurance perspective – protection against a potentially
catastrophic risk to the quality and stability of the cash flow stream and the corresponding
value of the business. Obviously, insurance has a cost. So, how much interest rate
protection is needed, and for how long, has cost implications.
Managing interest rate risk revolves around the concept of "duration," which may
be broadly (and inartfully) defined as the weighted-average time to reprice the
assets and liabilities of a business. As an example, a slump in the value of the
dollar might result in higher interest rates, but might also boost businesses engaged
in the export market. An importer, on the other hand, might think about that quite
differently. Businesses that have their assets constantly repriced are not as concerned
about the impact of inflation or deflation on their business, whereas companies
that have long-duration assets and/or long-dated cost or revenue elements (e.g.,
manufacturing plants, long-dated real estate leases, long-term pricing contracts)
could experience a much greater impact. The point of this is that an appropriate
interest rate strategy for one business might not be well suited to another.
No company with variable rate debt can afford to ignore its exposure to interest
rate fluctuations. An effective interest rate strategy enables a business to better
manage its exposure to unpredictable interest rate conditions on the underlying
Banks are a prime source of expertise, as interest rate risk is central to their
business, but there are advantages to consulting an independent expert who can help
you fairly evaluate the amount and duration of insurance that is needed, the timing
of implementation, and the cost tradeoffs of utilizing different tools:
• The best alternative. Swap providers are in the business to make money. To
that end, bankers often push long-dated swap or collar contracts, with lucrative
embedded fees, rather than rate caps or other option-based hedging strategies that
provide adequate protection at a lower cost. Banks generally expect the same spread
on a swap or collar, which embody some credit risk based on the client's obligation
to make payments if rates fall. With an option-based hedge, there is no credit exposure,
which means the client can consider providers other than its credit bank[s].
• Real-time information. Breaking economic news can significantly move derivative-market
pricing in a matter of minutes. Since there can be material intra-day movements,
comparing multiple proposals over a several day period can be meaningless. An advisor
with access to real-time market data is best able to find the most favorable alternative.
• Pricing transparency. A swap quote includes imbedded profits for the provider.
An independent advisor can quantify the economics of various providers, so alternatives
are fairly compared.
The starting point is quantification of interest rate exposure and the potential
impact if left unhedged. Because rates are dynamic, regular review and adjustment
is necessary. Now, we would argue, is the time to initiate a careful interest rate
risk review with the objective of developing and executing a management strategy
customized to your business. Waiting is simply a decision to bear the risk.