Staying focused on the long term
At a time when interest rates are at or near 40-year lows, there's both good and bad news for investors. Over the past couple of years, investors with floating rate debt have enjoyed the benefit of some of the lowest short-term rates since the 1960s. The advantage of low rates is the reduced cost of acquiring and paying down debt.
So when long-term fixed-rate borrowers look at the phenomenally low short-term rates, they may forget why they wanted a fixed rate in the first place: to match the term of their asset with the term of their debt, a proven and prudent financing decision. Also, when the long-term debt was acquired, the difference (spread) between long- and short-term rates, and so the difference in interest rate payments between a fixed- and floating-rate loan, may have been relatively small.
As a result, investors renewing long-term debt for the first time since the late 1990s may be asking themselves, "Why should I renew my long-term debt with a long-term rate?" Yet, the decision to apply a fixed rate on long-term debt may still be prudent, especially given that long-term rates are at or near 40-year lows. Despite the uncertainty in today's geopolitical arena and economy, investors need to stay focused on the long term, and what might happen to the cost of their debt should rates rise.
How can you weather shifts in interest rates and the cost of borrowing? Previously, borrowers could change interest rates and debt maturity by relatively inflexible methods such as pre-paying (often with a penalty) and issuing new debt. With the advent of interest rate "caps," "collars" and "swaps," borrowers have additional options for responding to changing market conditions. No one can predict with absolute certainty what will happen in a fluctuating market, yet these hedging strategies can help limit your risks.
To see if caps, collars and swaps are right for you, ask your banker for assistance. He or she can help you assess the value of these strategies, whether you have a variable-rate or fixed-rate loan. Your banker will first analyze your needs and then show you how the different hedging instruments are likely to perform under various interest rate scenarios. Your banker will work with risk management specialists to identify your exposure so that you can select an appropriate hedge strategy that reflects what you consider to be an acceptable amount of risk.
Examples are noted below. (The interest rates provided in the examples are for illustrative purposes only and do not represent an actual quote.)
Caps: Caps provide a ceiling against any significant increase in short-term rates while allowing you to enjoy the full benefit from a possible decline in rates.
For example, on a five-year variable-rate term loan (priced at a 3-Month LIBOR rate of 1.30% plus 2.00% credit spread) with a current all-in-cost of 3.30%, you could purchase a five-year cap of 6.75% on the LIBOR rate. That would guarantee that your all-in-cost would never be above 8.75% (maximum LIBOR rate plus the credit spread). The cap is purchased with a premium paid in advance (as is the case with most insurance policies). If rates decline, you will have paid the premium, but will also experience the full benefit of the lower interest rate.
Collars: Collars provide a rate ceiling and a floor, thereby limiting interest rate movement within a range. For example, on the loan cited above, a collar could be purchased that would maintain your all-in-rate between 3.97% and 8.75%. The premium for this collar would be less than for the cap because your benefit from lower rates is limited. Some collars can be structured without payment of an up-front premium.
Swaps: An interest rate swap enables borrowers to reduce or eliminate interest rate risk by converting variable-rate interest payments into fixed-rate payments. In a transaction separate from the original loan, the client enters into a contract to exchange cash flows (i.e. receive payments equal to the floating interest rate, such as the LIBOR rate, and pay a market-determined fixed rate). As a result, the borrower's all-in cost stays the same, whether interest rates rise or fall.
Are caps, collars and swaps right for you? Given the current historical lows in interest rate markets and the uncertainty of the future, it's wise to at least evaluate your debt structure and the potential role of hedging instruments. With information from your banker and our financing experts, you can find the answer that's in your best interest.
Wayne E. Mueller is a Private Banker with Wells Fargo Private Client Services. He focuses on assisting high net worth clients with wealth management and creative banking solutions; email@example.com or 946-8702. BN