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 and an improving housing market. Because of the continued progress, Yellen indicated the Federal Reserve’s intention was to raise interest rates as method of curtailing inflation. Yellen recently noted that, “monetary policy affects economic activity and inflation with a substantial lag,” and that “it would be imprudent to keep monetary policy on hold until inflation is back at two percent.” As a result, in the past two years interest rates have increased on five occasions; the most recent increase being on December 14, 2017. This increase was promptly followed by major banks increasing the prime rate from 4.25% to 4.50%. These actions by the Federal Reserve appear to mark a commitment to steadily increase rates.
Impact of a Rising Interest Rate Environment
Not much of the interest rate discussion and activity in late 2016 and 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, you should prepare for rate increases to continue 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. Experience and conversations suggest otherwise. Recently, there have been 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:
Example 1
Company A executed a $1,000,000 term note on January 1, 2018 to fund a large construction project. Interest is charged at the variable rate of prime. Interest only payments are due each December 31 until maturity on December 31, 2022. Assume the prime rate is 4.50% on January 1, 2018 and increases 0.75% each subsequent January 1 through maturity.
| DATE | PRINCIPAL | PRIME RATE | INTEREST |
| 01/01/18 | $ 1,000,000 | ||
| 12/31/18 | 1,000,000 | 4.50% | $ (45,000) |
| 12/31/19 | 1,000,000 | 5.25% | (52,500) |
| 12/31/20 | 1,000,000 | 6.00% | (60,000) |
| 12/31/21 | 1,000,000 | 6.75% | (67,500) |
| 12/31/22 | $ 1,000,000 | 7.50% | (75,000) |
| $ (300,000) |
The schedule above indicates Company A would pay $ 300,000 of interest during the five years the $1,000,000 term note was outstanding.
Example 2
In addition to the original assumptions above, assume Company A executed an interest rate swap contract on January 1, 2018 with a notional value of $500,000. Under terms of the swap contract Company A is the fixed rate payer at 5.00% through maturity on December 31, 2022. Company A’s bank is the variable rate payer at Prime less 0.25%.
| NOTIONAL | VARIABLE LEG | FIXED LEG | |||
| DATE | VALUE | RATE | INTEREST | RATE | INTEREST |
| 01/01/18 | $ 500,000 | ||||
| 12/31/18 | 500,000 | 4.25% | $ 21,250 | 5.00% | $ (25,000) |
| 12/31/19 | 500,000 | 5.00% | 25,000 | 5.00% | (25,000) |
| 12/31/20 | 500,000 | 5.75% | 28,750 | 5.00% | (25,000) |
| 12/31/21 | 500,000 | 6.50% | 32,500 | 5.00% | (25,000) |
| 12/31/22 | $ 500,000 | 7.25% | 36,250 | 5.00% | (25,000) |
| $ 143,750 | $ (125,000) | ||||
The amortization schedule above indicates Company A would receive $143,750 of interest during the five years the interest rate swap contract was outstanding, but also pay $125,000 of interest (a net gain of $18,750). 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 $300,000 of interest during the five years the $1,000,000 term note was outstanding but would receive $18,750 from the bank as a result of the interest rate swap.
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 $300,000 in interest over 5 years. Example 2 had Company A exposed in the market on $500,000 and fixed the interest rate on $500,000, which ultimately led to Company A paying a net amount of $281,250 in interest over 5 years.
Although my examples above show Company A paying less interest when using a swap, the assumptions could be easily changed to show Company A paying more than $300,000 over 5 years. It is a common misconception that an executed interest rate swap guarantees a company will pay less interest. 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.
Summary
We had been hearing about expected rate hikes for quite some time and the Federal Reserve has begun to act. 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.
