The last several years we've seen historically low interest rates. Eventually these rates will rise and that may be sooner rather than later. This is the third in a three part series about managing the risk of rising interest rates. You can find the overview post here and the second post that details the economic indicators of rising rates here.
Interest Rates: Risk to Be Managed
The consensus of economists’ forecasts is that the Federal Reserve will begin raising short-term interest rates in the middle of 2015 if improvements in the economy and labor market remain on track. That means interest rates on new and existing variable rate loans will rise in tandem with increases in the Fed Funds rate. It is highly likely that rates on longer-term fixed rate loans will also rise toward historical norms. As a result, borrowers should assess their exposure to rising interest rates and explore the alternatives that are available to limit this risk to a level that is well within their tolerance levels.
Fixed rates: Current level of fixed rates is very low relative to history
Longer-term fixed rates have little room to decline but significant potential to increase, as the 5-year U.S. Treasury Yield chart indicates. Borrowers should review their exposure to rising interest rates and determine whether fixed rate financing alternatives may benefit them.
Source: Bloomberg
Some borrowers choose to borrow money at variable interest rates, because the initial interest rate on a variable rate loan is typically significantly lower than a fixed rate loan for the same term. The borrower accepts the risk that interest rates could rise, resulting in even higher payments at a time when the borrower may be least able to afford them. Lenders are willing to lend at variable rates, because they are easy to match fund with floating rate borrowings or short-term deposits.
In an environment such as today’s — when interest rates are likely to rise — a borrower may typically benefit from locking in a low rate. The lender, therefore, faces taking the interest rate risk or needs to match fund the loan in the capital markets. Farm Credit System lenders have excellent access to the longer-term capital markets via Federal Farm Credit Banks Funding Corporation fixed rate debt issuance. As a result, they can offer a full range of fixed rate borrowing alternatives to borrowers wanting to limit interest rate risk over the term of their debt.
Although the cost of borrowing at fixed rates will initially be higher than borrowing at current variable rates, fixed rates offer several advantages, especially when interest rates are expected to rise:
- CERTAINTY. With fixed rate loans, borrowers know what their monthly payments will be for the full term of the borrowing. This eliminates the risk of higher debt service payments in the later years of the loan. The certainty of interest costs over the term of the borrowing may be especially welcome to agricultural producers. That’s because other input costs, such as energy and fertilizer, as well as commodity prices, may move in directions that reduce profit margins by increasing operating costs or reducing revenues.
- VALUE. A variable interest rate loan requires less cash flow to service the debt initially than a fixed rate loan. However, if interest rates rise, a producer who locked in a fixed rate may benefit from significantly lower interest costs over the long term. This would be especially true if the FOMC is forced to raise rates more aggressively due to an unexpected or unwanted increase in inflation. Prepayable fixed rate loans through Farm Credit offer the borrower additional value, because the cost of the prepayment option is priced at a relatively low cost versus the risk due to the cost-efficient funding for these loans.
- FLEXIBILITY. Extending out maturities and locking the availability of borrowings for longer terms delays rollover funding risk until the loan matures. Borrowers should strongly consider prepayable fixed rate loans to reduce the risk of longer-term fixed rates falling to new lows. This could happen due to an unforeseen economic or geopolitical event, or if the FOMC is faced with inflation well below its target, or deflation. In the past, prepayable fixed rate loans have enabled many borrowers to refinance at lower fixed rates when longer-term fixed rates have declined. Furthermore, the incremental cost of financing using prepayable loans is currently very low relative to fixed rate make-whole loans (see Prepayment Option Cost chart below).
Source: Federal Farm Credit Banks Funding Corporation (FFCB)
Cash management: another interest-saving solution
Obtaining a low interest rate and locking in a fixed interest rate aren’t the only ways to save on borrowing costs. Cash management solutions combined with a revolving line of credit may also yield significant savings on interest and fees.
Many large farm operations have a revolving line of credit as their operating account. Some lenders offer the opportunity to combine a revolving line of credit with cash management solutions, including an account much like a liquid money market investment account that can be used to receive and make payments. Such an account may also help borrowers save on interest costs or even earn interest.
The customer can:
- Deliver business receipts directly to the revolving line of credit, minimizing the loan balance and related interest charges
- Use credit line drafts to pay bills, incurring interest charges only once a draft is actually processed
- Earn interest that’s comparable to a three- to six-month CD — when placing more funds into an account than needed for the loan, the excess funds are automatically invested into the money market-like investment account
Yet another cost-saving opportunity: A combined revolving line of credit, cash management and money market-like investment account enables customers to keep all their banking activities at one institution. This eliminates fees for transferring funds between institutions.
Information in this post was provided by AgriBank. AgriBank is FCS Financial’s funding source. It is one of the largest banks within the national Farm Credit System, with more than $80 billion in total assets. Under the Farm Credit System’s cooperative structure, AgriBank is owned by 17 affiliated Farm Credit Associations. The AgriBank District covers America’s Midwest, a 15-state area from Wyoming to Ohio and Minnesota to Arkansas. More than half of the nation’s cropland is located within the AgriBank District, providing the Bank and its Association owners with exceptional expertise in production agriculture. For more information, visit www.AgriBank.com.
