Brett Symes: Senior Agribusiness Consultant
The Reserve Bank recently noted that banks long-term debt funding has declined to record lows because of a fall in base interest rates as financial markets begin to price in a reduction in cash rates. It must be remembered that while home loan rates closely follow movements in the Reserve Bank cash rate, business rates, though correlated, are not as closely linked. Interest rate swaps however, do provide a clue as to where Bank business rates should be.
An interest rate swap is a financial instrument where one entity swaps a stream of floating interest payments for another entity’s fixed interest payments. Currently, swap rates are the lowest they’ve been in 6yrs, with the previous low occurring around August 2016. In fact, 10yr swap rates are very similar to variable rate (30d) swaps, hence the premium to fix, in theory, is marginal.
So, do you ‘manage your greed’ and fix rates at 40+ year lows, or do you keep riding the variable rate joyride and hopefully pocket more savings?
The answer lies within. In other words, what’s your assessment on the likelihood of movements in interest rates (i.e. what’s your crystal ball saying?), what’s your business’s risk capacity under those scenarios, and what’s your personal risk attitude?
Risk capacity and attitude to risk
Risk capacity is your business’s ability to sustain higher interest rates. For example, can your business afford to pay an extra 2% on interest rates, or would that cause financial hardship? Even if your business could buffer a 2% interest rate rise, your attitude to risk also matters. A risk-averse individual may not sleep at night under the threat of that happening, so they can eliminate that worry by locking in interest rates and having budget certainty. In this way, they are effectively paying an ‘insurance premium’ to manage the risk.
As far as the crystal ball goes, predicting the movement of interest rates is a bit like trying to predict the movement of exchange rates and commodity prices; not that easy! Longer term rates had increased around 0.90% since the 2016 low, with plenty of commentary at the time that we had passed through the trough and to pencil in sustained rises. Now rates are around 1% below that 2016 low, and potentially heading lower!
Yield curves tell us the current lending rates however, they do not accurately predict the future, with many economic factors affecting the eventual outcome. The challenge of trying to pick the market low (i.e. the point at which they turn the corner and increase) is that the futures almost always lead the floating low by many months.
Finance Tender Analysis Tool
One way to analyse whether to fix interest rates or not is to use a spreadsheet tool such as ORM’s Finance Tender Analysis tool to model different scenarios to help make the decision. This exercise brings probability into decision making. For example, you might be more confident in allowing for a 2% rise in variable interest rates over the next 5yrs than only allowing 1%. Then armed with that assumption you can run an analysis and calculate if you’re better off paying a premium (if any) now to fix, versus continuing to run on variable rates and allowing for the 2% rate rise over the period. Keep in mind that the longer the variable rate doesn’t increase, the more it has to increase over the remaining period of analysis for you to be no worse off. For example, if the premium to fix was 0.5%, but you didn’t expect variable rates to increase for 2.5yrs, then they could increase 1% in the last 2.5yrs of a 5yr analysis to be no worse off, because you’d have pocketed the savings in the front half.
Always keep in mind that the variable vs fixed debate is only one part of a robust finance structure. Knowing where the market is sitting and securing competitive finance that suits your attitude and your businesses capacity is an integral part of a good farm business strategy.