By Roger J Kerr
Fixing of interest rates has not been a value-enhancing strategy for all borrowers over recent years.
The high NZ dollar value and the Christchurch earthquake maintaining the OCR and wholesale 90-day interest rates at the record low levels for 3 ½ years now.
The opportunity cost of corporate borrowers fixing via swaps or mortgage borrowers fixing with their bank has been substantial and could well be persuading some borrowers to revise their interest rate risk hedging policies.
That would be a mistake, as hedging policies (percentage fixed and the term of fixing) should be determined and governed by the borrower’s own financial risk sensitivities and materiality, not where market interest rates happen to be right now.
The volatility and drivers of NZ interest rate direction should also be taken into account when designing an appropriate hedging policy for a borrower; however they are secondary to the borrower’s own financial metrics.
Striking the balance to these variables is the key to successful interest rate risk management over the medium to long term.
Changing a hedging policy to a much higher weighting of floating rate risk due to the very low sub-3.00% 90-0day rates over recent years may be enticing to some, however the real risk is that the opportunity to fix interest rates at record low historical levels out to ten years forward may be lost.
If the decision to fix is now delayed by policy changes to when the RBNZ lift the OCR sometime next year (or the year after), the very real risk is that the three to 10 year swap rates will be more than a 1.0% higher then to what they are now.
Corporate risk managers need to look further ahead than the just next 12 months.
To achieve the right balance, the decision to “pay-away” the difference on fixed rate swaps for the next 12 months must be made now for the overall longer term benefit.
If the three to 10 year swap rates are still well below 4.0% in 18 months time it means that most companies will have more problems than “out-of-the-money” interest rate swaps on their books.
A continuation of the super low market interest rates over the next 18 months would mean that the global economy has turned down again into a double dip recession and the massive monetary stimulus from the Federal Reserve in the US has not worked for their economy. The New Zealand economy would be back into recession under this (highly unlikely) scenario.
The contrary view is that the US economy is moving again at the household level with house prices up and new building also up. US 10-year Government bond yields have yet to break out of their tight trading range between 1.5% and 1.8%, however improving US economic data and some kind of resolution to the fiscal cliff problem are more likely to cause a move upwards rather than downwards in yield.
The US bond yield remains the principal driver of our three to 10 year swap interest rates.
One piece of interest rate market intelligence that is well understood by most corporate borrowers is that when mortgage borrowers have any hint that the next move in the OCR is upwards, they will all rush to fix mortgage rates at once. The resultant one-sided demand on the wholesale swaps and Government bond markets is always going to send term rates up sharply.
We do not know the exact timing of this change in sentiment; however prudent borrowers will not want to be making fixing decisions in the middle of the inevitable stampede.
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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com
3 Comments
There is still a 1% premium when fixing longer term (say 5 years vs floating), that is a very big price to pay for certainty. what is gong to drive consumers to suddenly demand fixed rate debt? Unemployment is rising, the economy is not really growing, consumers are deleveraging and not spending more than they have to.
I'd be inclined to take a bit of risk off the table and fix some debt but I will continue to take advantage of the floating rate and have the majority of my debt floating.
Very little risk of interest rates rising within the next 3 years. Everything is going down (apart from unemployment). Govt is slashing the tertiary education budget. Govt is slashing Govt dept budgets. Govt is abandoning any Regional economic devt. Consumers are still battening the hatches. CPI is flat or falling. SMEs are getting out of business. Fortunately for young NZ-ers they have Aus as an option. NZ & Aus shelter from the global problems is running out.
Fix for a maximum of 6 months - it's similar to floating - you get a far better rate and can still re-fix a few months down the track if need be.
You argue against yourself. You point out that if rates are still low in 18 months' time then companies will have bigger problems to worry about. In other words, companies' performance is linked to the economy, which is fair enough - but given that that is so, why would a company want to be still paying unnecessarily high rates if the economic environment is so poor? If they are surviving by the skin of their teeth then every cent saved in interest (now and in the future) could be crucial. Conversely, if the economy has improved then companies' profitability ought to be better able to cope with higher rates.
Companies have already suffered hugely if they locked into long term hedging every time you've called the low. One day you will be right, but only the survivors will take any notice.
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