In March 2017, the Federal Reserve maintained its positive outlook on the U.S. economy when Federal Reserve Chair Janet Yellen referenced several domestic statistics, including decreasing jobless rates, an improving housing market and limited inflation. Because of the continued progress, Yellen indicated the Federal Reserve’s intention was to get interest rates closer to a more neutral level to allow the U.S economy to grow at a moderate rate. Then, on the heels of these comments from Yellen, the Federal Reserve bumped the short-term federal funds rate by a quarter point. This increase was promptly followed by major banks increasing the prime rate from 3.75% to 4.00%, only the third such increase in the prime rate since the Great Recession of the late 2000s. The March 2017 actions by the Federal Reserve appeared to mark a commitment to steadily increase rates.
Since March, the U.S. economy has lagged in certain respects (e.g., first quarter’s 0.7% GDP growth rate is the lowest in three years), lawmakers in Washington have quibbled over proposals from the Trump administration, and expected proposals on tax reform have not made it to the floor. In light of this, the Federal Reserve announced on May 3, 2017 that it will maintain its current position and keep rates steady for the time being. Several media pundits that dissect comments from the Federal Reserve on a regular basis continue to suggest that we will see two more rate increases from the Federal Reserve before the end of 2017. Some suggest those increases will come in September 2017 and December 2017.
Impact of a Rising Interest Rate Environment
Not much of the interest rate discussion and activity in late 2016 and early 2017 comes as a surprise. The market has anticipated and expected increases in interest rates for quite some time. The steps taken by the Federal Reserve have been cautious. If you have variable rate debt, however, current thoughts and feelings would suggest you will see steady rate increases in the near-term. And whether that variable rate debt is based in prime or LIBOR does not matter because the two benchmarks have been nearly perfectly correlated for the last 20 years.
Some businesses indicate that fluctuation in rates is never expected to be significant enough to impact them. My experience and conversations suggest otherwise. Recently, I have been asked an increasing number of questions about alternatives, including the use of interest rate swap contracts. For those unfamiliar, interest rate swap contracts are financial derivatives used to fix some or all variable rate debt. To illustrate, here are two examples:
Company A executed a $5,000,000 term note on January 1, 2017. Interest is charged at the variable rate of prime. Interest only payments are due each December 31 until maturity on December 31, 2021. Assume the prime rate is 3.00% on January 1, 2017 and increases 0.50% each subsequent January 1 through maturity.
The schedule above indicates Company A would pay $1,000,000 of interest during the five years the $5,000,000 term note was outstanding.
In addition to the original assumptions above, assume Company A executed an interest rate swap contract on January 1, 2017 with a notional value of $3,000,000. Under terms of the swap contract Company A is the fixed rate payer at 4.00% through maturity on December 31, 2021. Company A’s bank is the variable rate payer at Prime less 0.25%.
The amortization schedule above indicates Company A would receive $562,500 of interest during the five years the interest rate swap contract was outstanding, but pay $600,000 of interest, too (a net pay out of $37,500). Additionally, because the interest rate swap contract is a separate agreement, the swap does nothing to change the original executed term note. Said differently, Company A would still pay $1,000,000 of interest during the five years the $5,000,000 term note was outstanding. In all, then, Company A will pay $1,037,500.
In summary of the illustrations above, Example 1 left Company A exposed in the market to fluctuations in variable rates, which ultimately led to Company A paying $1,000,000 in interest over 5 years. Example 2 had Company A exposed in the market on $2,000,000, but fixed the interest rate on $3,000,000, which ultimately led to Company A paying $1,037,500 in interest over 5 years.
Focusing on these examples, then, why would any business execute an interest rate swap contract if they are going to pay more in interest? Although my examples above show Company A paying more interest when using a swap, the assumptions could be easily changed to show Company A paying less than $1,000,000 over 5 years. I choose these assumptions to illustrate that an executed interest rate swap contract does not guarantee a company will pay less interest. That is a common misconception. Interest rate swap contracts come in all shapes and sizes, and their results can be unknown because the market is unpredictable.
Ultimately, an interest rate swap contract should not be executed with an expectation to make money by paying less interest than the variable market. Rather, the goal should be to reduce or remove anxiety about increasing interest rates and the impact that could have on your business, and to provide a fixed ceiling if interest rates increased significantly (e.g., in the examples above, no matter what happened in the market, the interest rate swap contract fixed $3,000,000 of the total $5,000,000 outstanding at 4.25%: term note’s prime – less swap’s prime minus 0.25% + swap’s fixed 4.00%).
We have been hearing about expected rate hikes for quite some time and the Federal Reserve has begun to act, albeit cautiously. They, too, will continue to proceed with care in light of mixed results in the U.S. economy for the first quarter of 2017. However, on May 3, 2017 the Federal Reserve suggested the lagging results of the first quarter were “transitory” and they will maintain the current monetary policy. It is expected that rates will be increased two more times before the end of 2017. If your company has variable rate debt, understand that it will be impacted by these changes. While interest rate swap contracts are a method to reduce the impact of changes in interest rates, they do not guarantee you will pay less interest overall. And, interest rate swap contracts are not the only option.
For more information on how a rising interest rate environment could impact your business and whether an interest rate swap may be beneficial, contact your CSH advisor or email me at [email protected].