The Fixed Versus Floating Interest Rate Conundrum: 5 Factors to Consider When Choosing Your Mix

In our many years of advising borrowers of all shapes and sizes, in a myriad of 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 continuum?

With interest rates near historical lows, many are prompted to “fix it and forget it” while others realize that the higher interest rates that come with “fixing” force them to give up significant interest expense savings when absolute certainty isn’t necessary. Instead of deciding on fixed vs. floating on a particular loan, larger 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, with each operating within unique industry nuances, each having unique profit margins or IRR requirements as well as plans around the assets being financed and the overall business strategy that drives their acquisition, use, and disposal.

Despite the nearly unlimited variation among borrowers, the following five topics should be considered when formulating the all-important fixed-floating mix:

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 business’s ability to tolerate higher interest payments also improves. Conversely, when economic times are tough, interest rates would be generally lower, thus interest expense a lighter burden.

“Fixing it and forgetting it,” 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 fixed interest payment less palatable. We often hear, “We’re a very conservative company, we only borrow at fixed interest rates.” That’s a great strategy when the business performs, until it doesn’t.

Capital Structure – The mix of debt versus equity on an entity’s balance sheet as well as a company’s ability to match assets and liabilities to take advantage of natural offsets.

The greater the amount 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. This is especially so 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 the amount of debt it can take on relative to income.

A company with strong cash flow coverage ratios able to withstand swings in floating interest rates should position itself toward the floating end of the spectrum. Conversely, a company with weak cash flow coverage ratios may prefer the certainty of fixed interest expense and position itself toward the fixed interest rate end of the spectrum.

What about 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 more debt.

Rates & Volatility – Economic trends, the shape of the yield curve, the expected future path of interest rates and the degree of volatility that’s expected in-between.

While floating interest rate borrowers enjoy the low-interest payments that have resulted from years of rock-bottom interest rates, they should ask themselves what the eventual series of Fed hikes – which will result in higher short-term rates – will mean for the business.

All borrowers, despite their place on the fixed-floating continuum, should ask themselves if higher short-term rates would derail business opportunities and the financing or refinancing needs that go with them. Sure, interest rates could fall, even go negative, but eventually, it’s highly likely they’ll have to rise.

Peer Comparison – How will your company, its debt levels, and 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 higher future coupons that will come from higher long-term rates and spreads
• If your cash flows and credit ratios tolerate a 100-basis point rise in future funding costs

…and your strategy should be:

• Get out in front of higher interest rates by using Treasury locks, forward starting swaps or swaptions
• Start thinking about pre-funding. Conduct a break-even analysis of funding early versus doing nothing

Also consider:

• How the steepness of the interest rate curve and interest rate volatility impacts your hedging costs and limits your choices

If you’re largely a FLOATING RATE borrower, you should be thinking about:

• The higher short-term rates that will come from eventual Fed hikes and the conclusion of extraordinarily loose monetary policy
• If your cash flows and credit ratios tolerate a 100-basis point rise in future funding costs

…and your strategy should be:

• Consider rebalancing your debt’s fix-floating mix
• Buy “disaster” interest rate protection
• Start thinking about pre-funding. Conduct a break-even analysis of funding early versus doing nothing

Also consider:

• How the steepness of the interest rate curve and interest rate volatility impacts your hedging costs and limits your choices

How You Compare to Your Peers

Source: Derivative Logic’s independent, proprietary study of mid-market, public and private

corporates in their use of floating interest rate debt, risk assessments of doing so and hedging activity.

Take Away

• Each organization’s perfect place on the fixed-floating rate spectrum is unique and there is no perfect solution. If you ‘ve made quick decision on where to be on the continuum or stuck with 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 better manage risks that your business operations cannot.
• Be proactive rather than reactive.
• Hedging is a dynamic process – risk management isn’t static. Don’t just “fix it and forget it”. Buy and hold doesn’t work in today’s marketplace.

Not confident about how to use the fixed versus floating interest rate debt mix to your company’s advantage?  Call us.

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