Is your Floating Rate Loan Really a Fixed Rate Loan?

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Change impacts all aspects of life.  This is especially true in capital markets.  Managing an investment portfolio or capital structure isn’t a static exercise, it’s dynamic. Let’s briefly reflect upon the recent turn in market sentiment towards lower interest rates and examine how this change has affected short term, floating rate financing, specifically highlighting a danger awaiting borrowers.

What’s Changed

Unless you’ve been living in a cave the last six months, you’re likely aware of the dramatic change that’s occurred in the bond market’s expectations of the future direction of short-term interest rates. All indicators are now pointing to a world (literally, the globe) of lower rates. For the US, this change in sentiment is reflected in the downward shift in expectations of where 3-month LIBOR is headed.

3-month LIBOR: Where markets thought it was headed a year ago, six months ago, and today

Source: Bloomberg Professional

The dark line above illustrates how markets expect 3-month LIBOR (and most short-term rates) to fall even more over the next couple of years then slowly begin to rise consistently after that.

Correspondingly, Fed Fund futures market traders, who are in the business of predicting what the Fed will do, among other things, assign a 98% probability to a 0.25% Fed rate cut at the September 18th meeting (red) and a 65% probability of another 0.25% cut at the Fed’s October 30th meeting (yellow):

Source: Bloomberg Professional

These expectations for future Fed rate cuts and lower short-term rates in the near term are the continuation of a global trend, where pretty much every developed economy’s rate expectations have come down consistently, quarter after quarter, since 2014. The Fed’s recent about-face from a rate hiking stance to a cutting one is a case of simply being late to the party. One can see this global move to lower rates in the consistent flattening of yield curves in the world’s largest economies:

Source: Bloomberg Professional

There is plenty to discuss regarding hedging strategies when yield curves are flat/inverted and market expectations predict lower short-term rates.  However, this time around we’ll spare you the relevant discussions on hedging rate risk with caps, collars, swaps, or swaptions.  Sure, pretty much every borrower loves the prospect of interest rates coming down, but there is a specific danger we’ll discuss that lurks about that you need to be aware of.

Floating Rate Loan with a Floor = A Fixed Rate Loan?

Many LIBOR-based, floating rate loans have a floor embedded within them. What’s a floor? Its essentially language contained in the loan agreement that states that no matter where LIBOR goes over the life of the loan – up or down – the borrower’s monthly interest rate will always be calculated based at least on the level of the LIBOR floor, or higher, plus the credit spread.   Here’s an example assuming a 3-year, LIBOR-based, floating rate loan with a 2.00% floor and a 3.00% credit spread:

  • Say, in month 24 of the loan, 1-month LIBOR is 2.25%. The borrower’s interest rate that month is 2.25% + the 3.00% credit spread = 5.25%
  • In month 30, let’s assume 1-month LIBOR has declined to 1.75% (the Fed cut rates by 0.50%). The borrower’s interest rate that month is 2.00% (remember the 2.00% floor) + the 3.00% credit spread = 5.00%
  • If LIBOR consistently stays below the 2.00% LIBOR floor, the borrower is essentially paying a fixed rate; the 2.00% floor + 3.00% credit spread = 5.00%, even though 1-month LIBOR is markedly below the 2.00% floor for much of the loan term. That’s why they call it a floor… got it?

Yes, that’s right. Even though LIBOR declined, the borrower’s rate didn’t decline with it to the same degree due to the floor. LIBOR floors aren’t always bad for borrowers, but they can be.

Here’s a problem with floors we’re consistently seeing right now. Most loans from a bank have a 0.00% floor, while most floating-rate loans from bridge lenders have floors in the range of 1.75% to 2.50%.  The levels of these floors were put in place when LIBOR was higher and market expectations were pricing in Fed hikes as opposed to now, when rates are lower, and the momentum has moved toward them going even lower still. Here’s a simple chart illustrating how floors we see consistently are far higher than the market’s expectations for where LIBOR will go in the future.

3-month LIBOR Expectations versus Common LIBOR Floors

Source: Bloomberg Professional

Floors Are Risky

What does this mean for a borrower with a floating rate loan and an embedded floor above expected LIBOR expectations? As in the example above, if the floor is 2.00% or 1.75% on a 3-year loan, the borrower technically has a fixed rate loan with no cost benefit if rates breach the floor.  In fact, a loan with a “high” floor – one that is notably higher than where markets expect LIBOR to be in the near future – is even riskier than a fixed rate loan. Why?

  • The borrower can’t benefit from lower rates
  • The borrower is at risk if rates rise

In our experience, floating rate lenders tend to be reactive and slow to adapt to changes in LIBOR expectations. Market expectations have completely changed the attractiveness of floating rate borrowing with high floors.  Some lenders are lowering floors to accommodate the change, but many have not.  Again, a floating-rate loan with a 2.00% or 1.75% floor is essentially a fixed rate loan that offers no benefit to the borrower when rates breach the floor, yet exposes the borrower to a rise in rates in the unlikely event it occurs. 1-month LIBOR will likely trade below 1.75% by the end of the year. A 0.25% to 0.50% savings in interest expense could be the make-or-break difference in the success of a project.

Where is Your Floor?

The interest rate landscape has changed. Expectations for short-term rates moving lower have grown and the probability that they’ll stay low is the new reality.  To remain competitive, smart lenders have re-evaluated their floating rate programs and adjusted their floors to sync with the market’s LIBOR expectations.  Smart borrowers are keen to avoid the added risk a high LIBOR floor presents to their deal and demand a sensible floor or no floor at all.

As advisors, our job is to proactively work with lenders to reevaluate embedded floors in loan agreements. The starting point in those negotiations is current LIBOR expectations.  We help negotiate with lenders on a borrower’s behalf, not by bullying, but by justifying lowering floors based upon market realities and prevailing, long-term interest rate expectations.

Take-Away

In our decades of experience, the current rate environment tells us one thing: flexibility is paramount to any risk management decision.  Avoid reacting too quickly because you think term-rates are low and you have to impulsively take advantage of them.  Tread carefully and seek the advice of Derivative Logic to help guide you toward a sensible, customized strategy.  As an aside, in this inverted yield curve environment, banks push hard to get borrowers to execute interest rate swaps.  It’s an easy sell because short-term rates are higher than swap rates.  Trust us when we say that you have time to learn and adopt a well-thought out, sensible hedging strategy. Often times, the best strategy is to not hedge at all. Please call us at (415) 510-2100 for guidance.

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