Should you be fixing your interest rates?

Should you be fixing your interest rates?

Businesses owners continue to enjoy the benefits of record low interest rates and with some experts predicting the Reserve Bank’s official cash rate could fall to as low as 1.5%, it’s understandable why you might adopt a “do nothing” stance. The RBA could reduce the Cash Rate further in the months ahead but that doesn’t mean your wont be paying more for your money. And remember the old saying “no-one got rich trying to pick the top or bottom of the market”. So is now a good time to fix your interest rates and what are the factors you should be considering?

The table below clearly illustrates how rates have fallen in recent years. Sure, rates could fall further, particularly if fears about the Chinese economy become a reality, but how much lower can they go?

interest-rate-graph

Source: CBA

Do you know that by going fixed now you could lock in a rate at about the same level as what you are currently paying on a variable rate? As a busy business owners with no end of issues to deal with this would give you one less thing to worry about!

A recently concluded commercial property investment we advised on was funded with a fixed three-year debt facility at 2.36% (excluding lending margin), which compared to the prevailing 90-day floating rate of 2.33%. In this case the borrower was happy to pay a small three basis point premium to have certainty of funding costs for the term of the loan.

Another benefit of locking in your interest rate is it can also reduce the risk of being exposed to rising bank lending margins.

Margins and fees are what banks add to their base funding costs. Banks are under constant pressure from the market and shareholders to maintain earnings growth but with wholesale funding costs rising, flat demand for business credit and uncertainty in the housing market, it can be a real struggle for them.

Ultimately it is the customer, both borrower and lender, who will be squeezed and what this means for borrowers is pressure on margins. By locking in an all up two- or three-year rate that includes the base funding cost plus the bank’s margin, you will be able to minimise the risk of the bank forcing up margins as part of any interim review.

Many borrowers have been put off fixing rates due to horror stories about break costs imposed by banks. In 2008 the 30-day bank bill rate was around 7.50% and as rates fell, some borrowers were caught out when they wanted or needed to get out of the loan. A lack of understanding of how fixed rates work and poor transparency about how banks calculate break costs fuelled many ugly disputes but two things have changed.

Firstly, with rates at or near historic lows the prospect for substantial further falls and therefore break costs are limited. So if you took a fixed rate now and rates rose then you would receive a benefit if you broke a fix rate agreement. And secondly banks are now much more transparent about how they calculate break costs.

Here are six steps to managing interest rate risk to your business:

1. Understand your interest rate risk
How would a fall or increase in your interest bill affect profits and liquidity in your business? How comfortable are you with taking a risk on the future direction of interest rates? What are the likelihood and consequences of a dispute with your bank over interest rates?

2. Develop an interest rate risk management policy

Once you understand your interest rate risk, you can formulate a policy to deal with it.

The more conservative position is summarised by the attitude of: “we’re in the business of supplying widgets, we’re not in the money business and we don’t want to take any risks on interest rates so we will fix our rates whenever possible”.

But even this conservative approach involves risk. For instance, if you fix your rates but then rates fall, competitors that remain floating will have a cost advantage that could make it more difficult for you to compete.

There is no right or wrong interest rate risk management policy. A policy to take no protection against adverse rate movements is still a policy.

3. Don’t sign up for a product you don’t fully understand

Banks have a myriad of ways to help you manage your interest rate risk. Other than straightforward fixed rates, banks can offer you options that come with caps, collars and floors that can be mind boggling even for the sharpest business owner.

Banks go to considerable lengths to satisfy themselves that clients understand what they are buying but don’t just rely on what the bank thinks. It’s your responsibility and if you are in any way unsure the “Keep It Simple, Stupid” or “KISS” approach is best.

4. Understand the bank’s perspective

When a bank assesses your standing as a borrower, they will want to know about your interest rate risk management policy. Sometimes they may even impose a condition on the loan approval that you fix some or even all of your rates.

The cynic might say this is simply a ploy to generate additional revenue, although there can be no dispute that this does and should play an important role in the bank’s credit assessment and approval process.

5. Use interest rate swaps for transportability

Straight fixed rate arrangements are usually entered into either via a fixed rate agreement or an interest rate swap. The former is a loan with an inbuilt fixed interest rate. With a swap, the fixed rate component is a separate transaction established outside the loan and it is governed by a document you need to sign called an ISDA.

The rates are the same in both options but the big difference is a swap is transportable. This means you can take the debt to another bank and the swap just stays in place, whereas if you wanted to take a fixed rate loan to another bank, you would have to unwind the fixed rate contract, which is separate procedure that may also involve additional costs. So, all things being equal, a swap gives you more flexibility than a fixed rate agreement.

6. Shop around

Treasury divisions are big profit centres for the banks. They don’t offer these products for free and standard benchmark rates like the Bank Bill Swap (BBSW) are not used when quoting rates. It’s always a good idea to ask around to ensure that the deal you are being offered is a competitively priced one.

A bank has several stakeholders in addition to its customers and while in the vast majority of cases it will act to protect and enhance your interests, you are responsible for managing your interest rate risk as well as other business risks. In dealings with your bank we suggest an approach of: “Trust but verify”.

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