In our decades of assisting companies in their management of interest rate risk, we hear one question frequently:
“I’m conservative and only borrow at a fixed interest rate. Why should I care about hedging interest rate risk?”.
It’s a fact that floating rate debt typically represents a small percentage of a company’s debt load. However, all debt will mature eventually, and when it does, you’ll have to face the music of interest rate markets at that time. For most companies, this future refinance risk dwarfs the current risk presented by floating rate debt. In the following paragraphs, we outline the key tenets of the best practices of interest rate management, laying out a road map for borrowers to follow to come to the right decision while eliminating common myths and misconceptions along the way.
Understand the Fixed Rate Premium
Most of us like certainty – any time we can control outcomes, we feel relaxed and empowered. However, protecting oneself from uncertainty comes at a cost. Fixed rate debt is nothing more than insurance against the volatility of floating interest rates. As a borrower, you should always know if fixed rate debt is cheaper than floating debt and vice versa. Said another way, is the net present value of all fixed interest payments less than that of floating interest payments? Unfortunately, this question can’t be answered until maturity of the floating rate loan being considered and thus the analysis can’t be made without establishing some assumptions about where interest rates are headed. While arguments on why rates will rise or fall may sound compelling, no predictions – not even ours – are accurate beyond a few months, and are proven to be only random guesses over time.
Take-away: Forecasting interest rates, and basing your financing decisions on a forecast, is a loser’s game.
Become View Neutral
Whether one will admit it or not, most companies plan their financing strategy around their view of where they believe interest rates are headed. If they think rates will rise, they finance with fixed rate debt. If they think interest rates will fall or remain stable, they finance with floating rate debt.
While determining a company’s inherent breakeven point – the interest rate above which they’re better off fixing and below which they’re better off floating – is a fun exercise, its utterly useless. Why? No one really knows where interest rates are headed over the long-term, and therefore, if they’ll rise above or fall below a company’s breakeven point. If you’re adhering to an interest rate strategy that is driven by the flawed assumption of the future direction of interest rates, you are doomed to fail.
Take-Away: A “view-neutral” strategy of managing interest rate movements – one that does not allow a view of where rates are headed to affect your decision on whether to borrow at a fixed or floating interest rate is always best.
Use the Absolute Value of Treasuries to Determine if Fixed or Floating Rate Debt is Best
We’ll spare you from a detailed linear regression analysis of the correlation between 10-year treasury yields and whether fixed versus floating has proved to be the cheapest interest rate strategy historically. Trust us when we say the lower the 10-year Treasury yield, the greater the probability that fixed rate debt will cost less than floating rate debt over a 10-year period.
While fairly obvious, this fact is often ignored. In fact, most companies do the exact opposite, as they extrapolate a recent month long bond rally/fall in Treasury yields into a long-term trend and keep or increase their floating rate exposure. Conversely, as term rates rise, they assume it’s a temporary blip until it’s too late, panicking and fixing their interest rate near the peak. We’ve seen this error-filled dynamic play out with borrowers over and over again over our two decades in the capital markets. But we’re all smart, right? So how can this happen?
- Borrowers don’t have a long-term strategy for managing interest rates,
- They are reactive rather than proactive, and
- It’s safer politically to have floating rate debt in a low interest rate environment and fixed in a high interest rate environment; a stance that will significantly add unnecessary interest rate expense to an organization over time
Take-away: The more interest rates fall, the more your debt portfolio should be fixed. If you’re already 100% fixed, the more you should extend your debt maturities via forward hedging. Conversely, the more interest rates rise, your debt portfolio should be less fixed and more floating.
Ignore the Shape of the Yield Curve
Now that the flat Treasury yield curve is dominating the financial headlines, we’re repeatedly asked, “Hey, long-term rates have come off their highs and overall, have risen less than short-term rates. Shouldn’t I be borrowing at a fixed rate?” Not so fast. Contemplate this scenario: You’re evaluating your financing options and are choosing between borrowing for 5 years at a fixed rate of 3.5% or at floating rate of 2.5%. Which should you choose?
Some thoughts to consider:
- How fast would LIBOR need to rise in order for the floating rate to become worse than the fixed rate (what’s my breakeven rate)?
- What’s the likelihood it will happen (what’s my view on future interest rates)?
All three of the questions above refer to the flatness of the yield curve for answers, and are irrelevant – here’s why:
- Determining the breakeven rate is reliant upon forecasting future interest rates, which at best is a random guess.
- The true cost of the badly needed cash flow today is totally unknown for the same reason, as its calculation relies heavily on forecasts of future interest rates.
- Yield curves change on a minute by minute basis, and forecasting how they’ll look in the future involves taking a view on future interest rates, again, a random guess no matter how well informed.
- The yield curve for LIBOR is a terrible predictor of future interest rates. Check this out:
LIBOR Forward Curve: How Accurate of a Predictor?
It’s a graph of LIBOR Futures curves – the multicolored lines and the only real predictor of interest rates – against where LIBOR actually traded – the bold red line – over the last 16 years. Any specific LIBOR futures curve in the graph is a snapshot of the markets best guess of the future path of LIBOR at that point in time. As you can see, there were very few instances (other than the blue shaded area) where LIBOR actually followed the path markets had predicted.
Unfortunately, most borrowers use the LIBOR yield curve, or the Swap curve (which is derived from the LIBOR curve) as the main determinate of whether to borrow at a fixed or floating interest rate. Borrowers who ask, “How much more over LIBOR will I need to pay if I borrow fixed?” are falling victim to the flawed method of using the worst predictor of future interest rates – the LIBOR yield curve – as the driver in deciding upon fixed versus floating rate financing.
Take-away: The LIBOR yield curve – the most common tool for forecasting interest rates – is a terrible predictor of the future path of LIBOR. Hence, its shape and positioning should be ignored when forming a strategy for determining if fixed or floating financing is best.
Separate Current Interest Rate Risk from Future Rate Interest Risk
A true interest rate strategy considers the risk of volatile interest rates not only to current cash flow, but to the future health of the organization. To their detriment, most companies only think of interest rate risk in the context of floating rate debt, which is usually only a fraction of the risk to the company, leaving the much larger risk unattended: the risk that the interest rate on future debt will be detrimentally high once a company’s current fixed rate debt matures.
Current Interest Rate Risk is the risk rising rates will negatively impact current cash flows, e.g. soon to mature floating rate debt.
Future Interest Rate Risk is the risk that rising interest rates will result in a higher than expected rate used to refinance maturing debt in the future. e.g. the interest rate on a loan used to refinance a construction loan. Future costs of financing affect future cash flows.
Take-away: Interest rate derivatives allow companies to manage future interest rate risk separately from the debt’s maturity schedule, allowing them to take advantage of low rates while avoiding substantial pre-payment penalties that come with fixed rate debt.
Separate Liquidity Risk from Refinance Risk in Future Transactions
Liquidity risk is the risk that funds are available for refinancing at a similar LTV or cash flow coverage. This type of risk can only be hedged with a prohibitively expensive forward loan or equity commitment.
Refinance Risk is the risk that interest rates are so high in the future that future deals will be economically unattractive.
Take-away: The majority of Refinance risk comes from interest rate risk, which can be eliminated or significantly reduced by hedging with interest rate derivatives, allowing a company to lock in favorable interest rate levels regardless of debt maturity schedules.
Develop a Road Map for Acceptable Interest Rate Risk
A long-term interest rate strategy should have two goals:
1) to create the longest stream possible of known interest expense, and
2) to drive down interest expense over time. Most of the time, these goals are mutually exclusive, but there are times when they’re not, and organizations must act strategically to take advantage of opportunities to accomplish both goals when it exists.
How can one tell when the opportunity exists? Map the organization’s interest expense over the relevant time horizon, accounting for the risk to interest expense, whether from floating rate debt and/or refinanced fixed rate debt, enabling the organization to see the risk it faces and when it faces it. Only then can one contemplate hedging.
Take-away: Developing an interest rate risk map offers an organization the greatest possibility to create the longest stream possible of known interest expense, and drive down interest expense over time. Without it, an organization is flying either partially or completely blind.
Don’t Go It Alone
The cost of debt is arguably the largest single expense a company faces. Driving down the cost of borrowing by even a small amount often dwarfs cost reductions from streamlining operations or, in the case of commercial real estate, the revenue enhancement from decreased vacancy.
For borrowers, it’s critical to:
- Develop a long-term debt management strategy based upon proven principals,
- Become proactive rather than reactive to changes in the financial markets, and
- Be disciplined in adhering to the strategy
In our experience, an organization’s priorities and political environment are in constant flux. It often helps significantly to involve an independent third-party to rise above the fray and develop a long-term debt management strategy based upon optimal interest rate risk management tactics. Even if an organization creates a sound interest rate management strategy, poor execution can be a major obstacle to the fulfillment of any plan. Avoid the pitfalls of poor execution – overpaying, costly documentation errors and/or hedge unwinds by working with hedging professionals.
Don’t know where to start? Put our decades of experience to work for you.
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