Interest rates vs. profitability Featured

7:00pm EDT December 31, 2006

Every time the Federal Reserve gets together to discuss rates, business people take notice to see what the Fed is going to do. Its role is to control monetary policy to “promote maximum employment, stable prices and moderate long-term interest rates.” It primarily meets its objective by setting a target federal funds rate (the rate that the Fed charges depository institutions to borrow money to meet their overnight reserve requirements). To control inflation, the rates are tightened (or raised) to slow down the economy and loosened (or lowered) to speed it up.

“As the Fed lowers or raises the federal funds rate, banks need to adjust the rates that they charge their customers when they lend funds or pay their customers on deposits,” says Patti McKee, executive vice president and chief financial officer at ViewPoint Bank in Plano. “The rates charged and the rates paid can certainly have an affect on the profitability of a business.”

Smart Business asked McKee for more insight on ways businesses can use information on rates to positively affect their profitability.

Why is it important to keep an eye on the Fed rates?

Most business loans are set to a spread to the prime rate. In other words, if it goes up, borrowing costs are going to move up. If it goes down, borrowing costs go down. If the business has an adjustable-rate loan, the rates will go up or down according to the terms of the loan.

Most overnight investment-type accounts (money market and sweep accounts) for liquidity are based on Fed funds. So, as the Fed rates are increased or decreased, the amount of money that can be earned on overnight deposits will be affected.

How can a business person use this information to affect profitability?

First of all, keep in mind that loans can be obtained with rates that are either fixed or variable and tied to an index. Fixed-rate loans set the interest rate for the term of the loan. Interest rates on variable-rate loans can change as soon as the Fed rates are announced or according to schedule. They may change every 30 days, 60 days, quarter, or whatever else is stated in the terms.

To avoid paying more on your loans than what you earn on your investments, you must put into place a good investment strategy while maintaining enough liquidity to meet operations. One common method is laddering terms and rates so that not all of your investment money is re-priced as rates move.

Variable loans are usually tied to an index, either prime or the U.S. Treasury curve. As the rates move, so does your cost of loans. The best practice is to match your earning assets to your cost of liabilities so that as rates change, the impact to your profitability is negated.

What is the yield curve and how does this affect me?

The yield curve is a plotting of yields that U.S. Treasury bonds pay from three months to 30 years. This is a good tool to get the overall movement of interest rates. It measures what you can get or pay for short-term money compared to long-term money.

In a normal yield curve, you should get rewarded for placing your money in a longer term compared to shorter term. However, the yield curve today is inverted. This means that interest rates for shorter terms are higher or equal to those with longer terms.

Why might you invest longer when you can get paid more for a shorter term?

An inverted yield curve is generally a sign of lower interest rates in the future. While you may think you are sitting pretty with a high-yielding six-month certificate, in six months when the certificate matures, the rates could have moved down significantly and you will have money to invest in a much lower-interest-rate market compared to what you would have if you would have locked into a longer term.

The best strategy is to look at your cash needs and try to match the terms of your investments to those of your liabilities. Also, keep your banker informed of your needs and work with him or her to best plan your strategy.

PATTI MCKEE, CPA, is executive vice president and chief financial officer of ViewPoint Bank in Plano. Reach her at (972) 578-5000.