The Federal Reserve has raised rates seven times in the past three years and has indicated it will increase rates again this year and in 2019 as part of its dot plot. The Fed has been open with its intentions and plans to hike interest rates on a slow and measured pace, according to Andrew Barnette, East West Bank's first vice president, interest rate contracts. Depending on the inflation rate and various other economic factors such as GDP growth, employment data and geopolitical concerns, the Fed could choose to continue raising rates or pause their hikes.
“The central bankers’ current plan is to hike interest rates by a total of three to four times in 2018 and two to three times in 2019,” says Barnette.
As a result of these rate increases, borrowing costs for small and medium-sized businesses have risen, especially for companies that have variable rate loans, which will be impacted the most because the prime rate will also rise.
“A lot of our borrowers currently have loans that are due to mature in the next one to three years,” Barnette says. “They’re evaluating whether they should refinance now or wait until the loan matures.”
Refinancing is a good option for some companies because it can lower the monthly payments. One drawback is that the repayment terms will be extended. A benefit is that it improves the cash flow of a business, freeing up money to expand the company or in other areas such as marketing or sales.
“Most business loans are variable rates,” says Jose Juan Vega, first vice president and manager of small business development at East West Bank. “For example, many types of business loans may have a low interest rate, but short repayment period and high monthly payments. Refinancing a loan with a longer period may effectively reduce the monthly payment and improve the cash flow of the business.” Vega explained that refinancing can also “be used to reorganize the current debt structure.”
“Refinancing a loan with a longer period may effectively reduce the monthly payment and improve the cash flow of the business.”
The general rule is to refinance only when the current monthly payments are reduced by about 20 percent. “This can be achieved by either lower interest rates or an extended repayment,” he says. However, one caveat is that refinancing fees typically range from 1 percent to 3 percent of the total loan amount and more interest will be paid because the length of the loan will be longer.
While a loan from the Small Business Administration (SBA) cannot be refinanced by another SBA loan, one option is to refinance it with a non-SBA loan, such as a real estate-related loan or a different bank loan, Vega said.
Every company has different financing needs—a business that wants to pay off its debt in the next two to three years may not be a great candidate for refinancing, Barnette adds. Since the future is uncertain, it is a good time for companies to reevaluate their existing loans and whether utilizing an interest rate risk management product is beneficial to hedge against the costs of rising interest rates.
“It depends on the type of loan and their view on interest rates and risk tolerance,” Barnette said. “Some companies will take out a longer-term loan to buy a building, which typically has a term of five to 10 years, compared to other companies that will take out a line of credit to fund ongoing capital needs on a shorter-term basis.”
A business with a line of credit that matures in one or two years is probably not a good candidate for a fixed rate debt swap, while a company which has a 10-year loan for a building purchase will probably not want to do a one to two year interest rate hedge because the company will be exposed to rising interest rates for the last eight years of that loan.
“Just because a borrower has a 10-year loan does not mean a borrower is guaranteed to hedge,” Barnette says. “Some business owners think the Fed will not follow through on the projected rate hikes, while other business owners think they will do even more interest rate increases than are currently projected.”
Business owners typically opt for caps, collars and swaps to manage interest rates and the risks associated with rising and declining rates. These products allow flexibility, and borrowers do not have to wait for their current contracts to expire, shares Barnette. They can terminate an existing hedge contract, and the termination value can be used to adjust the interest rate up or down in conjunction with entering into a new contract.
“They have the ability to do something today if they want to—they do not have to wait until 2020 when the interest rate environment could be a lot higher,” he said. “This is available for new and current clients.”
An interest rate cap is a contract that promises to pay the business owner a specified cash amount whenever short-term interest rates, such as the London Interbank Offered Rate (LIBOR), rise above a certain level. For example, Barnette explains, a business owner could purchase a LIBOR cap that would deliver monthly cash payments whenever prime is above 4.5 percent. If the business owner had a $10 million variable rate loan, the cap could cover all or a portion of the $10 million loan. The business owner also has the freedom to choose the level of the cap.
If a business owner believed that interest rates will move higher over time, purchasing a structured cap is another option. The cap can be set at a certain percent for the first two years, then stepped up (increased) for the last three years of the contract. For instance, the business could structure the cap for a total of five years with the first two years at 4.5 percent and the last three years at 5.25 percent.
“It gives clients flexibility on where they manage their risk, and they are not necessarily stuck to a single interest rate protection level for the life of the contract,” Barnette says. “It also helps with the cost of the contract.”
One disadvantage is that caps require the payment of an upfront fee. Business owners who want to skip the fee often chose an interest rate collar. An interest rate collar is an interest rate cap combined with an interest rate floor. For example, a business owner could obtain a LIBOR cap at 4.5 percent for “free,” if he accepted a LIBOR prime floor at 1.95 percent. The floor would obligate the business owner to make monthly payments whenever LIBOR is below 1.95 percent.
An increasing number of entrepreneurs are considering collars because of where they can strike the floor, Barnette adds.
“They want the interest rate cap protection, but don't want to pay for it,” he says. “A borrower can currently strike the floor below 2 percent, which is safely below the current LIBOR, and still get a cap in the mid-4 percent range. We are seeing a lot of customers structure collars with a specific cap and floor in mind, since some have a mandatory hedge requirements. This is a compromise solution, and they are protected without any upfront cash outflow.”
"A borrower can currently strike the floor below 2 percent, which is safely below the current LIBOR, and still get a cap in the mid-4 percent range."
Future hedge payments then depend largely on where LIBOR lands during the term of the loan. For example, if LIBOR fell below the collar floor the company would not get the full benefit.
Another option for managing rising interest rates is to use an interest rate swap.
Interest rate swaps also have a variation that includes the option to cancel. These contracts are advantageous to companies who want the certainty of a fixed rate, but the flexibility to terminate without paying a fee, Barnette says. This strategy is good for a company that is concerned about more rate hikes, but in the event that the economy stalls, they can exit their fixed rate option at no cost.
Choosing one of these interest rate risk management products is not an easy choice for businesses to make, but they help companies hedge against rising interest rates in the short-term.
“The future path of interest rates is unpredictable, which is why it is important for companies to think critically about their interest rate hedging program,” he says. “There are a number of interest rate risk management products available, and the flexibility of these products—in structure and in execution timing—allows companies to customize their approach to managing interest rate risk.”