Rates are Low and Falling: Should You Borrow Fixed or Floating?
5 Factors to Consider When Choosing Your Mix
In our many years of advising borrowers of all shapes and sizes in myriad industries, when thinking of interest rates, one question remains steadfast in the minds of Treasurers and CFOs:
Where does my company’s debt portfolio belong on the fixed – floating spectrum?
With fixed interest rates near historical lows, and even lower than floating rates in some cases, some borrowers are prompted to “fix it and forget it”. It’s certainly a tantalizing prospect. Other borrowers realize absolute certainty isn’t necessary and opt for the floating route, knowing that such gives them more flexibility down the road. Instead of deciding on fixed vs. floating on a particular loan, smart borrowers with multiple debt obligations on their books must look at their entire debt portfolio and strike a balance between risk and opportunity cost.
No two borrowers are the same, each operating within unique industry nuances, and each having unique profit margins or IRR requirements. No two borrowers have the same plans for the assets being financed and the overall business strategy that drives the acquisition, use, and disposal of assets varies wildly from one borrower to another.
Despite the nearly unlimited variation among borrowers, everyone should consider the following five issues when formulating the all-important fixed-floating mix within a debt portfolio.
Business Profile – The business’s unique performance through the business cycle.
A business whose performance mirrors the expansion and contraction cyclicality of the overall economy would benefit from more floating interest rate debt, the logic being that as the economy performs better, the firm’s ability to tolerate higher interest payments as rates rise also improves. Conversely, when economic times are tough, interest rates would be generally lower, allowing interest expense to be a lighter burden on the business when it needs it most.
“Fixing it and forgetting it,” i.e. having all fixed rate debt on the balance sheet, often proves troublesome to companies whose profits mirror the business cycle. When the economy suffers, profits and cash flows will as well, making a fixed interest payment troublesome. We often hear, “We’re a very conservative company, we only borrow at fixed interest rates.” That’s a great strategy when the business and the economy performs, until it doesn’t. The world and US economy are both slowing at present. What type of debt – fixed or floating – do you have on your balance sheet?
Capital Structure – The mix of debt versus equity on an entity’s balance sheet as well as a company’s ability to naturally offset assets and liabilities
The greater the percentage of debt, the less tolerant a company is to changes in interest expense, hence highly levered companies should establish and maintain more fixed rate debt versus floating in general. This is especially true when the company’s margins are thin.
Credit Ratios and Covenant Restrictions – Specific loan terms that measure a company’s ability to pay its debts and restrict loan flexibility
A company with strong cash flow coverage ratios can withstand swings in floating interest rates. This type of company should position itself toward the floating end of the debt spectrum. Conversely, a company with weak cash flow or liquidity coverage ratios may prefer the certainty of fixed interest expense and position itself toward the fixed interest rate end of the spectrum.
Key question to ask yourself: Do I have prepayment flexibility? If the company expands as it hopes, will it be able to take on more debt in the future? Fixed interest rate debt obligations generally restrict a company’s ability to seize new business opportunities that require refinancing or taking on more debt.
Interest Rate Volatility – Economic trends, the shape of the yield curve, the expected future path of interest rates and the degree of volatility expected
While fixed rate borrowers enjoy the certainty that results from fixed interest expense, they should ask themselves what looming Fed cuts – which will result in lower short-term rates – will mean for the business. Key question: Is the business positioned to take advantage of the coming world of even lower interest rates?
Peer Comparison – How will your company, debt levels, and its place on the fixed-floating continuum, be viewed by equity investors when compared to competitors?
While our CEO, CFO, and Treasurer clients may feel confident in their choice of fixed-floating interest rates, it’s critical they learn as much as they can about what their competitors are doing.
The bottom line: A debt portfolio of either all fixed or all floating rate debt holds significant risk for a borrower.
Where are you in the fixed – floating spectrum?
If you’re largely a FIXED RATE borrower, you should be thinking about:
- The lower future coupons that will come from lower long-term rates and spreads
- If your current fixed interest expense will still look palatable given a 50-basis point fall in future funding costs, and most importantly, how much prepayment flexibility you have.
…and your strategy should be:
- Get out in front of coming lower interest rates by reviewing your ability to use forward starting swaps or swaptions to take advantage of lower rates when planning for future financings
- Start thinking about refinancing – conduct a break-even analysis of prepaying versus doing nothing
- How the steepness or flatness of the yield curve and interest rate volatility impact your ability enjoy lower fixed rates or limit your choices
If you’re largely a FLOATING RATE borrower, you should be thinking about:
- The degree to which you can participate in lower short-term rates that will come from looming Fed rate cuts (Do you have a LIBOR floor you don’t deserve?)*
- How your cash flows and credit ratios process a 50 to 75 basis point fall in future funding costs, and how you can enjoy the prospect of lower floating rates in your business now
…and your strategy should be:
- Consider re-balancing your debt’s fix-floating mix
- Explore ways in which you can manifest expected future lower rates in your business now
- How the steepness of the yield curve and interest rate volatility impact your hedging costs and limit your choices
The Value of Floating Rates in a Low Rate World
With many fixed interest rates across the curve at/near/or below floating rates, we’re being inundated with inquiries asking, “Should I just fix my rate and forget it?” The question is real and justifiable: With 1-month LIBOR at ~2.27%, and a 10-year bank swap rate at ~1.95% – well below one month LIBOR – it seems like a slam dunk to borrow at a fixed rate or borrow floating then fix the rate with an interest rate swap, right?
Hold your horses. Trust us when we say that, in general, the worst time to borrow fixed (or fix a floating rate with an interest rate swap) is when fixed rates are below floating rates. Here’s why:
Historically the fixed-below-floating dynamic is a temporary anomaly; if it persists long enough, the Fed will eventually cut rates to correct it. If you fix your rate before the Fed cuts, then you miss out on floating rates going even lower. Further, interest rate derivatives (e.g. swaps, rate caps, collars and swaptions) can manage interest rate risk far better than your business operations can. Let’s imagine that you fixed your rate, an economic downturn hits (a real possibility in this environment) and your business slows in lockstep with the economy. That fixed interest expense you once thought was a “slam dunk” begins to hurt. We’ve seen this movie before and experience has taught us that it’s far more difficult, and takes far longer, to draw down inventory or cut expenses in the business to offset the now-painful fixed interest expense than to have set up your financing such that financial derivatives do it for you.
Bottom line – deciding on the right fixed vs. floating debt mix is an art, not a science. Want to gain the tools you need to up your game on your fix-versus-float analysis? Contact us.
- Smart borrowers look at their entire debt portfolio and strike a balance between risk and opportunity cost.
- Each organization’s perfect place on the fixed-floating rate spectrum is unique and there is no perfect solution. If you‘ve made a quick decision on where to be on the continuum or failed to assess the same philosophy for any time longer than one year, you’re taking unnecessary risk.
- Don’t be afraid of floating rate debt. Financial contracts (derivatives) can manage interest rate risk better than your business operations can.
- Be proactive rather than reactive.
- Hedging is a dynamic process – risk management isn’t static. Don’t just “fix it and forget it”.
*A postscript: Given the current expectation of rate cuts in the near future, floating-rate LENDERS should reevaluate embedded LIBOR floors in their loan agreements and adjust accordingly. BORROWERS, make sure any embedded floor is at a level which is consistent with market expectations for LIBOR. Give us a call for guidance. Beware locking in a rate because it’s lower than 1-month LIBOR. Before succumbing to what may seem is a “no brainier” or a “slam dunk”, call us to assess the risk of doing so. In the current interest rate environment, flexibility is of the utmost importance.
Not confident about how to use the fixed versus floating debt mix to your company’s advantage? Contact us.
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