Managing risk on debt in a rising rate environment

For the past eight years, short-term interest rates have been largely unchanged. Many borrowers during this time have become complacent, believing the historically low rates to be the new normal. Their perceived risk, then, was that they didn’t have any. Now things are beginning to change.

The end of 2015 saw the first 0.25 percent hike in the federal funds rate. Three more would follow through 2016 and into this year.

“People are just beginning to believe the trend is real,” says Jim Altman, middle market Pennsylvania Regional Executive at Huntington Bank. “They’re seeing that the economy is getting better and that has led to higher levels of confidence.”

However, he says borrowers who are managing a company’s interest rate risk are beginning to question their position as rates begin to rise.

“While no one knows what will happen next, people are recognizing the economic indicators and the market is starting to react,” Altman says. “Borrowers are seeing their risk increase and are becoming concerned about it.”

Smart Business spoke with Altman about the current interest rate environment and what it could mean for businesses and borrowing.

How are businesses dealing with the rising rate environment?

Many borrowers are now looking to manage their interest rate risk going forward. Companies are locking in rates today to protect against future uncertainty so that they can focus on their day-to-day operations.

Much of a company’s approach to the changing rate environment hinges on their position. What is their risk posture? What is their view of future rate movements?

The risk comes with floating-rate loans, which would be affected by an increase. Borrowers need to think through how that risk could affect them, understand how much of an increase their company could sustain, then determine if they need to take action.

With the difference between a two-year and a 10-year rate nearing a 10-year low, one strategy that some have been deploying is fixing rates for longer terms. Even though the economy is strengthening and the Federal Reserve is increasing rates, the yield curve is flattening, meaning long-term rates are increasing at a slower pace than short-term rates. Borrowers are able to get protection for a longer period at a relatively minimal higher rate.

How is the rate environment affecting the type of interest rate companies use?

A mix of fixed- and floating-rate debt can make sense for some companies. On one side, there’s no financial benefit to having fixed loans if rates were to decrease, so borrowers may choose to float. On the other side, some borrowers have a cash flow that’s so tight they can’t take the chance that rates will increase, so they fix.

There are a variety of approaches and reasons to take each. It’s all part of a company’s decision making. With a rate environment such as this, what’s most important is to understand what’s happening in the economy and listen to what the Federal Reserve is saying. As of this writing, the Federal Reserve is projecting that there will be three to four rate increases through the end of next year.

What should companies do to put themselves in the best position given the circumstances?

Regardless of what’s happening, what’s most important is that borrowers internally analyze their interest rate risk. They should be honest with themselves about how interest rates affect them and how much risk they’re willing to take. With that determined, they can have a conversation with their bank and together can structure a borrowing approach that manages their exposure and keeps it within their comfort zone.

The economy is improving, rates are moving higher and many things are in flux. With those changes comes a different rate and risk environment, which has bearing on a company’s position. Companies should rethink their position and work with their bank to devise a strategy moving forward.

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