The Federal Reserve Bank slashed interest rates in July and has indicated that the central bankers may continue their rate cuts in 2019 and 2020. Business owners should take the opportunity to examine their current loans, hedges and maturities to determine if refinancing now is a good decision, or whether to take on a new loan.
San Francisco Fed President Mary Daly has hinted at the potential for more interest rate cuts because the U.S. is still facing trade issues. Economists on Wall Street are estimating that further rate cuts will occur in the coming months. However, the Fed’s actions in the next 12-18 months is “still uncertain,” said Andrew Barnette, East West Bank's first vice president of interest rate contracts.
There are a variety of interest rate risk management products that can help protect your business from potential volatility. Hedging is a method that helps reduce risk and financial loss, a sort of insurance against negative events. The change in the interest rate environment has resulted in a “flurry of lending and hedging activity, as companies look to take on new debt or refinance existing debt at attractive levels,” Barnette said. Despite the uncertainty, both five-year and seven- to 10-year hedge rates have fallen by approximately 50 basis points (0.05 percent) since early May, which indicates that people believe the Fed will lower interest rates over the next 12-18 months, he added.
The Fed controls the overnight rate that banks and credit unions use when they loan reserve balances to each other, said Sam Brownell, a CFA and founder of asset management firm Stratus Wealth Advisors.
“Although the federal funds rate is only a very short-term rate used by banks and credit unions, many other important rates, such as mortgage rates and commercial loan rates, are impacted by changes in the federal funds rate,” he said.
Lower rates stimulate expansion in businesses and job creation, especially if growth slows or declines for two or more quarters in a row, said Alex Shvarts, CTO of FundKite, a New York-based funding platform that specializes in helping small to large businesses obtain working capital. Slashing interest rates means it is cheaper for business owners to borrow money, spurring them to grow and expand by hiring new employees, opening new locations or offering more products and services.
“Business expansion might need to be encouraged,” Shvarts said. “As the economy has been high for over a decade and enters the longest bull market on record, surpassing the longest expansion period of March 1991 to March 2001, many financial leaders are expecting a recession by the end of 2020.”
Refinancing when interest rates are declining is a good strategy since it will lower monthly payments, but it will extend the repayment terms, said Shvarts. Business owners can take advantage of a decline in interest rates and use it to expand their business, especially if higher rates were what was holding them back in the first place.
“The better shape your business is in, the more likely your business is to get premium lending rates—however, rates aren’t always guaranteed to stay the same,” he said. Although lower interest rates are appealing, business owners should be conservative with how much money is borrowed, in case the economy contracts or a large client chooses another company.
Since cash is the most valuable asset to any business owner, conducting a comparative analysis of their current loan versus a new loan will determine if refinancing will free up more cash flow to reinvest in either the current business or an expansion of operations, said Brownell.
If the cost of financing is more than two to three percentage points less than the return on investment for expanding operations, a business owner “would be wise to take advantage of an interest rate reduction,” said Brownell.
“This is a good time for business owners who have been considering an expansion of operations, either through working capital or larger capital expenditures, to consider moving forward with their plans,” he said. “No business decision should be made in a vacuum without considering the impact a loan could have on the cash flow of your current and future operations.”
However, speeding up an expansion because interest rates are expected to continue declining is not a good plan, Shvarts said.
“Don’t take out more money than needed just because rates are low,” Shvarts explained. “This could bite you if the economy dips and your business becomes overleveraged, or if rates are raised and your business does not have a fixed rate.”
He added, “However, it is not wise to create a need to expand simply because rates are low. When too many businesses expand and growth is too abundant, this causes inflation, which is one reason why rates go up in the first place.”
Since interest rates are now expected to move lower in the near future, many companies are now seeking fixed interest rate swaps, interest rate caps and interest rate collars, Barnette said. The most risk and volatility-averse companies are utilizing fixed rate swaps to lock in low, long-term rates, because current swap rates are actually below current variable rates.
“These types of companies see that swap rates have fallen around 50 basis points since May and want to be sure they lock in this interest savings, even if it means foregoing the possibility that swap rates may fall even further in the future,” Barnette said.
Companies that can tolerate more risk and volatility are choosing interest rate caps and interest rate collars. These products determine a maximum rate the company will pay on their debt that is higher than current swap rates, but these products also allow for the company to benefit if interest rates continue to fall in 2019 and 2020, he said.
Owners have several options when they are dealing with unpredictable interest rates. Determining which one is the best fit for the company can be challenging, said Shvarts. A rate swap offers a fixed rate, which works better when the economy is in a declining interest rate environment like the current one. Any rate hikes would not impact the loan. The swap does allow the borrower to terminate it if the economy changes.
Another option is the interest rate cap guard. It is a good tool to help avoid increasing short-term interest rates. If the rates increase above a predetermined level, the company will receive cash in return.
A collar is a more flexible option since it has a ceiling and a floor, and hedges against any increases in interest rates. But if rates decline, the borrower does not receive the full benefit, said Shvarts.
“It’s hard to know where the economy is headed and which product is worth the fees, but the unpredictability is what makes risk management all the more necessary,” he said.
When rates are constantly changing, the potential for tariff wars persists, and other economic and political factors are impacting the profit margins of a small business, another option is for a company to seek a short-term loan that matures in 18 months or less, Shvarts said.
“The economy is volatile, and the longer it grows and performs well, the more uneasy business owners get waiting for it to slow,” he said. “Until market forecasts level out, many business owners are operating with smartly calculated financial decisions so that they can still take advantage of these low rates and growth opportunities.”