In this article we move into a more technical discussion about interest rate risk. It’s a huge subject area, and one that we will look at over several articles. Central to the common objective of managing interest cost and volatility over time is an understanding of the dynamics between fixing a rate of interest over an extended period of time to provide certainly of the cost, or allowing the rate of interest paid to be at current prevailing rates on a floating basis.
Strategies formulated to manage interest rate exposures cannot avoid the fact that over a longer time horizon floating interest rates always undershoot the market’s expectations. But the opportunity cost of fixing is often borne by the corporate treasurer in the interests of providing stability over the interest charge. Much of this is down to judgement, the materiality of the interest charge to overall financial performance, and the sensitivity of the business to the prevailing interest rate environment.
Interest rate risk: the fixed versus floating debate
Figure one is a plot many treasurers will be familiar with. It shows that over a series of consecutive three-year periods going back twenty-five years a floating rate borrower pays off approximately 75 percent of the time versus a three-year fixing for the same period. The average payoff is 86 basis points. This is a US dollar plot, but the same effect consistently applies to other developed world currencies. It is a well-established and accepted fact that being a floating rate borrower is cheaper than being a fixed rate borrower, and that this effect strengthens the longer the period of borrowing considered.
But there are times when it pays off to be a fixed rate borrower. Although far from a perfect correlation figure one shows that these periods coincide with the start of the central bank’s rate hiking cycles in 1998, 2004 and 2015. These periods can be genuinely hard to spot however, especially when Central Banks use tools like quantitative easing to influence the yield curve.
Figure one: when has it been better to be fixed or floating over the past twenty-five years?
Some very simple economics
Treasurers need to think in pragmatic terms regarding interest rate risk and form an opinion as to how to manage it. Interest rate risk depends on levels of economic activity, and more precisely the balance between the supply and demand for cash. On the demand side we have businesses and governments who want to spend cash and buy real assets. While on the supply side we have investors and savers. Like any market the balance of supply and demand determines the cost, represented of course by interest rates both current and expected in the future through the yield curve.
But this cost should not just be viewed in its absolute terms, or its notional price, but also in real terms after inflation has been deducted. Real interest rates for me hold the key to whether cash is expensive or cheap. When inflation is higher than the interest rate then the balance of supply and demand for cash has tipped so that there is more supply than demand. Economic activity is subdued such that the return on cash is negative regardless of what the absolute notional rate is. Holding cash in this environment erodes its value, incentivising spending, providing of course the view is held that the economy will not deteriorate further. When interest rates produce a positive return on lending cash after adjusting for the rate inflation then the demand side of the economy holds sway. This demand side is willing to pay a higher price for cash and spend it on real assets bolstering economic activity. At some point however this positive real rate of return drags demand back as cash becomes proportionally more expensive versus the returns that can be made on the real assets it is spent on.
Because of these balancing forces interest rates have a natural propensity to return to the mean over time. This mean reversionary effect hovers around the general level of inflation with productivity improvements such as technological advances supporting long term GDP growth and interest rates just above this level. It’s why inflation targeting by central banks is so important because it gives both the demand and supply sides of cash within the economy some assurance that in the long term they have a relatively level playing field with their lending, investing, borrowing and spending decisions.
Real interest rates
Whether interest rates available are cheap or expensive is not dependent on the notional rate, but on the real rate. I want to establish the principle with you that fundamentally whether we consider cash expensive or cheap depends on whether the real rate of interest over the period being considered is likely to be negative or positive. Provided of course that the firm’s profits adjust to the level of inflation over a reasonable period of time then if the real rate of interest is positive then it is a genuine cost over the period, while if negative then effectively a borrower is being paid to borrow and invest in real assets. Taking the fixed versus floating question only at this level of analysis would indicate to the borrower to fix when real interest rates are negative and therefore likely to rise (mean revert) over time. Conversely, if real rates are positive over the borrowing period then maintaining a floating interest rate allows the borrower to potentially benefit from a fall in rates (or probably more accurately a failure for rates to rise as predicted by the yield curve over the period).
Figure two: real interest rates and Libor (short term rate) can indicate when fixing is better than floating the interest rate
Figure two draws together both short term Libor, real interest rates and, the fixed versus floating performance profile. Tentatively the following conclusions are possible:
- Our three periods when fixing for three years was cheaper than floating, 2002 to 2004 and 2015 to 2017 coincided with negative real interest rates and the beginning of the Central Bank’s rate hiking cycle.
- Although a short period in 1998 also showed fixing outperformance, real interest rates were positive and the window in which fixing outperformed floating was very short lived.
- Periods of negative real interest rates while not universally an indicator that fixing outperforms floating, certainly coincide with a prolonged period when the difference between fixing or remaining floating was proportionally quite small as demonstrated from 2009 to the present day.
Table one shows performance output from two strategies addressing the fixed or floating decision over the same twenty-five year shown in figure two. These strategies are:
- Remaining floating at all times versus fixing for three years.
- Apply a rule that states fix when short term Libor is higher than trailing nine-month average Libor and real interest rates are negative. I have called this the proactive strategy.
Table one: three-year floating performance versus fixing interest rates. Out performance is enhanced when the real interest rate are considered as well as the direction of rate cycle in notional terms
|Outperformance vs fixed
|Average out performance
|Proactive strategy: Fix when 3m Libor is higher than trailing nine-month average AND real interest rates are negative
Table one shows that the proactive strategy produces a further out performance of four pbs against a purely floating strategy. Outperformance using our proactive strategy occurs 84 percent of the time versus 76 percent when remaining floating all the time and the risk profile of both strategies is the same (see gain loss spread). This strategy results in a further four basis points of outperformance.
We have focused on the perennial “fixing versus floating” debate and established that over the last twenty-five years borrowing at floating rates of interest was cheaper than borrowing at fixed rates. However, fixing at certain times of the economic cycle, specifically when central banks start a hiking cycle, is beneficial versus remaining a floating borrower through these times. However, it can be difficult to get the timing correct. Introducing a consideration of real interest rate movements into the analysis can provide an enhanced view as to when to fix interest rates and benefit from further out performance over and above a default floating stance. Of course, interest rate risk cannot be managed purely from least cost perspective in many cases and an element of fixing rates is very often required for earnings certainty over an appropriate term. Balance is the key here, a situation that as treasurers we are all very used to.