A Question of Timing: To Fix or Not to Fix?
Even longer term rates are incredibly low from an historical perspective, with US 10 year yields still below 2.5%, despite the recent bond market sell-off. In fact, the only period which offered more favourable long term borrowing rates was during – and immediately following – World War II when the US Treasury enforced a ceiling on interest rates in order to lower the cost of the war effort. This required the Treasury to rely upon the patriotic zeal of investors to compensate them for poor returns – an intriguing repudiation of modern efficient markets theory!
With this in mind, a common belief amongst corporate borrowers is that rate hikes are imminent and now is the time to lock-in fixed rate debt at what appear to be historically attractive fixed term rates.
As such, many corporates are now taking the time to re-evaluate their fixed versus floating debt mix, looking to lock-in issued debt at these historically low rates. While a valid place to start the analysis, it’s important that we evaluate fixed-term interest rates in terms of both their nominal level, and also their level relative to their floating counterpart.
When one revisits the data with this in mind, we see that while fixed rates are in fact at or near historical lows, spreads over and above floating rates are now sitting above the long-run averages. In fact, the steepness of the yield curve has effectively doubled since the spread hit a post-financial crisis low of just over 1% in 2012, as shown below:
Chart: US 10 Year Swap rate (Blue, LHS) and Spread between 10 Year Swap rate and US 6 Month LIBOR (Green, RHS):
In other words, while rates remain low, the yield curve is steepening as markets begin to price in the probability of higher interest rates, anticipating the inevitable change of tack from central bankers as the world’s greatest experiment in extreme monetary policy comes to an end. How does this influence the fixed versus floating decision? We must start with how a company arrives at their optimal fixed versus floating debt ratio.
Calculating the Mix
The primary driver of a firm’s optimal fixed-floating mix should relate to the underlying business itself, rather than expectations over the future path of interest rates. Companies which are more cyclical – and whose cash flows are correlated to the business cycle – should have a lower proportion of fixed-rate debt compared to companies whose financial performance is not closely linked to the business cycle.
This is evidenced by the fact that in pro-cyclical manufacturing firms, fixed rate debt has historically made up less than 50% of total debt, whereas in less cyclical industries (such as utilities) companies tend to fix about 70% of their debt on average (see
“Fixed or Floating”
by Charles Brobst and Sylvia Huang,
Risk Magazine, March 2002
). Other internal factors which can influence the optimal fixed floating mix include the degree of leverage employed (for example debt to equity ratio), the existence of lending covenants and the volatility of underlying cash flow.
In many cases, these company-focused factors will suggest a target range for the proportion of debt that should be fixed, which in effect becomes the company’s interest rate hedging policy. Academic studies have shown that approximately three quarters of companies maintain such explicit fixed-floating targets.*
However, while these targets provide an approximate target or range, many corporate treasurers also evaluate market conditions to determine precisely what proportion of interest rate exposure should be fixed, as discussed above. Many often allow themselves an element of discretion in order to exploit market conditions to ensure that the effective cost of debt is minimised, while ensuring interest rate risk is kept within pre-determined limits.
With this in mind, the question becomes: What does today’s interest rate environment mean for debt issuers? The higher-than average steepness of the yield curve – as shown by the spread between six month LIBOR and the 10 year swap rate – means that while absolute rates are low from an historical perspective, the relative cost of fixed rate debt is starting to become high (albeit not nearly as high as it was back in 2010). Companies are therefore faced with the dilemma of whether to sacrifice the benefit of very low floating rates in order to lower the risk of interest rates rising more quickly than expected.
Choose your Instrument
One way of dealing with this dilemma is through the selection of hedging instrument. For example, a corporate looking to reduce its interest rate exposure might choose a cap instead of a swap – essentially an option that allows the holder to enjoy the ultra-low rates available at the short end of the yield curve, whilst simultaneously limiting their exposure to upward movements in short term rates. This ensures that the company is not forced to crystallise current above-average spreads on fixed rates. Further, it allows the firm the ability to customise the parameters of the hedge, such as the protection rate and the duration, to ensure that the all-in cost of debt remains below the current swap rate.
For those firms looking to take a view on rising rates (among other motivations), other strategies include forward starting swaps or ‘swaptions’ – allowing companies to benefit from the current low rate environment in the short term while ensuring they are protected from longer term exposure.
Interest rate hedging has recently been viewed as a less dynamic activity than the hedging of other classes of financial risk, such as currency or commodity risk. This is at least partially due to the low levels of interest rate volatility that we have experienced since the financial crisis, particularly on the short end of the curve. However, as the macro environment evolves it will likely become increasingly important to manage interest rate risk on a dynamic basis.
Balancing the benefits of historically low long term interest rates against the implicit costs of a steepening yield curve is likely to become an increasingly important challenge for corporate treasurers as we move closer to the end of the most extreme interest rate policy environment in history.
* “The Theory and Practice of Corporate Debt Structure”, Henri Servaes (London Business School), Peter Tufano (Harvard Business School), 2006