Certainty Will Cost You
Most of us like certainty. Any time we can control future outcomes, we feel empowered. However, protecting oneself from uncertainty comes at a cost. We all try to manage risk in our everyday lives, be it by purchasing life insurance, avoiding floods or earthquakes, or managing total payments on a home mortgage. In most cases, when fixed mortgage interest rates fell, one could refinance a home loan at little or no cost. Many borrowers went so far as to re-finance to monetize new found equity in their homes while managing to maintain approximately the same monthly mortgage payment. Does Bill Gates have collision coverage on his cars? Probably not because a Ferrari is a relative cost. Mr. Gates’ purchase of a Ferrari is likely equivalent to our buying a candy bar.
Re-finance Risk vs. Interest Rate Risk: What’s this difference?
Generally, most home loans have a free option that allows the borrower to re-finance a fixed rate without a pre-payment penalty. Unfortunately, for many home loan borrowers this free implied option may have little or no value.
As most real estate investors or non-home loan borrowers are aware, this isn’t the case with a fixed rate swap (unless it is in-the-money or has an embedded purchased Swaption), life company loan, CMBS, or non-callable bonds.Why? Because we tend to forget the risk borrowers face that is far larger than interest rate risk: re-finance risk. When a borrower’s fixed-rate debt matures, the borrower is subject to interest rate levels and credit market conditions at that time. At the peak of the financial crisis and several years into it, credit markets were extremely tight. Even those with stellar credit found it difficult to re-finance home loan debt. Similarly, commercial real estate investors and corporate borrowers face the same dilemma when having to deal with a loan about to mature. Fortunately, there are several ways to mitigate interest rate risk on loans coming due within the next few years, such as forward starting swaps, swaptions, or extending a swaps maturity.
What other risks are there? Many of our clients often overlook what we refer to as opportunity cost. That fixed rate that looked so good a few years ago is now painfully high compared to equivalent long-term rates and especially compared to low floating rates. If your industry peers have more floating rate than fixed rate debt, you could be placing yourself at a disadvantage by having greater interest expense. One factor to keep in mind to avoid opportunity cost is to evaluate how your company/asset does during economic downturns and upturns. Most borrowers often overlook natural hedges that help mitigate volatility in interest rates. Hedging against lost opportunity cost can also be mitigated with interest rate derivatives.
Leverage and Pre-Determined Income Stream
How much an entity is leveraged will also determine how much interest rate risk needs to be hedged. A borrower with low leverage may have the resources to self-insure or purchase interest rate caps in the event of a spike in interest rates.
Often borrowers fix interest rates because their loan is tied to an asset with fixed cash flows or investors have been promised a fixed return on their investment. This makes sense to lock-in the spread. However, is there risk if the fixed income stream falls because of an economic downturn? Keep in mind, the Fed will probably lower rates if the economy is in or about to go into a recession. What happens if the anchor tenant goes bankrupt, rents need to be lowered, or goods discounted? Do you want to be locked into a fixed loan payment in such a scenario, or would a payment that fluctuates in concert with the economic cycle be more attractive?
Questions, Answers, and Scenarios
Let’s look at a few scenarios to assist in the determination of whether to borrow at a fixed or floating interest rate:
Should a steel producer – an industry tightly linked to the broad cycle of the US economy – hedge interest rate risk by fixing all their debt? A definite NO. Why? If rates rise, there is high demand for steel. Conversely, if rates fall, steel prices will drop, equating to lower sales of steel, and a borrower who’s ability to continue meeting fixed interest payments is suddenly compromised. The operative concept in this scenario is for the borrower to maintain flexibility in their debt obligations. A fixed rate loan offers zero flexibility.
A real estate investor borrows from a bank and fixes the rate with a swap for ten years. The investor’s goal is to sell the property within two to three years. In this scenario, the borrower is adding risk, not mitigating it. A two to three-year interest rate swap – not a 10-year swap – is a more suitable hedge. Why? If the asset is sold prior to the maturity of the swap, as the borrower planned, and term interest rates are lower, the borrower would have to write a check to terminate the swap contract. Alternatively, an interest rate cap might be an even better solution because a cap provides flexibility and protection with no negative termination consequences. The moral of the story: A fixed interest rate doesn’t necessarily mean one has eliminated interest rate risk. In fact, fixing all debt might be adding risk to a borrower’s capital structure. A debt portfolio comprised of 50% fixed and 50% floating should be the starting point for building a debt portfolio.
Don’t Try This at Home
The cost of debt is one of the largest single expenses a company faces. Being in a position to drive down the cost of borrowing by even a single percentage point will usually dwarf the savings achieved from streamlining operations or the revenue enhancement from decreased vacancy in a property.
Most companies devote too little time to long term interest rate management. The primary goals of any borrower are basic: 1) to create the longest stream possible of known interest expense and 2) to drive the cost of borrowing down over time. To be successful, a company must be proactive, rather than reactive, to changes in the capital markets and be disciplined in adhering to their defined strategy. Do you have the expertise and time to do it right? Seek help by discussing your particular needs with an independent interest rate hedge advisor and begin formulating a strategy, as managing interest rate risk is never “one size fits all”. Seek advice from an advisor with broad experience across a myriad of industries to garner the best outcome. Don’t know any? Contact us.
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