Why should you lock-in rates for floating rate liabilities now?
Over the past few months, the global business cycle quickly transitioned from a ‘late cycle’ environment to a sharp contractionary phase on the back of the COVID-19 pandemic. The economic fallout has been drastic, with more people losing their jobs in the US in the last two months than in the last ten recessions combined. Amid the uncertainty posed by the virus and the decline in economic activity, US Treasury yields are currently close to the lower end of the multi-year range. Employing prudent leverage or using the historically low rates to fix existing borrowing costs has seldom been this attractive.
While there may be lasting damage to certain industries from this COVID-19 pandemic, we believe that the recovery will be faster than that seen in previous business cycles as ample fiscal and monetary policy is being promptly deployed. We view this as a supply oriented recession, and in the past, supply-driven recessions have seen faster recoveries than demand-driven recessions. In benchmarking this recession against the Global Financial Crisis (which was a demand-driven recession), we think that many market participants have become too bearish on the economic outlook.
The Fed has pledged to support the financial system, which in turn has helped to stabilize markets. The Fed’s liquidity provisions (otherwise known as ‘alphabet soup’) are quite extensive, and many of these tools are yet to be used. Thus far, the Fed’s communication channel has done the bulk of the heavy lifting. In an effort to keep financial conditions as easy as possible, policy rates are unlikely to rise from current levels until at least the end of 2022, as per the dot plot. We see zero as an effective lower bound and do not think that the Fed is going to push policy rates to negative territory. As Jerome Powell has stated on multiple occasions, the Fed has a large toolkit that does not include negative policy rates.
Even before the recent flight to safety on the back of COVID-19 economic fallout fears, low rates were reflecting key valuation anchors such as low growth potential, low inflation and a declining term premium. While employment and inflation expectations stay below the Fed’s long-term targets, we expect 10-year rates to trade in a lower range relative to history.
The path to a normalization in rates is predicated on a containment of the virus and eventual recovery of economic activity. 10-year US Treasury yields are near the lower end of our expected multi-year range (0.75% -2.75%) – we expect rates near 1.25% +/- 25bps by Q2 2021, as we are more optimistic on the economy than the consensus for the reasons we discussed above.
We expect higher interest rates, but our longer term expected range is low by historical standards
The asymmetry in potential outcomes ahead provides a good opportunity for investors with floating rate exposure to fix a portion of their interest rate risk. We don’t believe that rates can get much lower from current levels, whilst the market is currently pricing in very little in terms of rate hikes by the FOMC (The Federal Open Market Committee) over the coming years. On the other hand, we can easily see the path to normalization in policy rates. We would also note that the curve is quite flat currently relative to historical levels (i.e. very low term-premium is priced in), which means that one can hedge out longer maturities and still benefit from very low rates.
Given the current low cost of borrowing, adding capital through modest leverage is a compelling way to enhance returns. Based on the current low level of rates, as well as the asymmetry in possible future outcomes, we recommend locking in borrowing costs, both as a hedge (to increase the certainty in portfolio cash flows) and opportunistically. This enables clients to protect against the possibility of the Fed embarking on an interest rate hiking cycle within the next 3-5 years.
Leverage – A thoughtful approach
Within the context of clients’ overall balance sheets, leverage can also be used to monetize assets, providing the liquidity to achieve personal or business objectives.
We believe that working with our clients to manage their liabilities needs to be done with the same active and dynamic discipline that we employ in managing assets. Our J.P. Morgan Lending Advisors are here to work closely with our clients on conducting balance sheet reviews, gaining a clear picture of assets, liabilities and cash flows. This then helps to determine where, and how, leverage can best be integrated into longer term financial plans. A balance sheet review can help to assess progress towards important goals and objectives. It also gives provides an opportunity to evaluate liquidity needs and identify potential funding sources, such as real estate, investments, or other illiquid assets. In this broad context, we can help our clients determine if they are exposed to too much risk, such as having wealth concentrated in a single stock. Using a modest amount of leverage may be helpful as part of managing this risk exposure. In addition, our Advisor will explore factors to be considered as part of the management of our clients’ liabilities, including interest costs, asset and liability durations, and fixed and floating options. The overriding goal is to help build the appropriate capital structure to suit the specific situation.
It is a given that in periods when interest rates are low (like now), the strategic use of credit may be particularly attractive, allowing cost effective acquisition of assets, for example. However, even in a rising-rate environment, using credit may be advantageous or at times unavoidable, affording clients the liquidity to meet obligations, or to be opportunistic when tactical investment windows arise. We believe that leverage can be effectively used in all market cycles. Thus, we work with our clients to consider “how” and not just “when” to employ the strategic use of credit. Our J.P. Morgan Investment Specialists will work with our clients in order to implement a customized strategy to manage future liabilities.
Locking in Rates – A case study
A client with a substantial stake in a Hong Kong listed company that focuses on proprietary bond trading holds a diversified portfolio of fixed income assets with various brokers and banks. They have been investing with leverage and have a number of repo facilities with different financial institutions. The client recognizes the current low interest rate environment and has the conviction that the downside risk of interest rates going negative (or too negative) is low.
Taking a holistic view of the client’s balance sheet positions across multiple providers, J.P. Morgan recommended a 3-year interest rate swap with a notional amount matched to the client’s long-term target debt capital level in order to help the client express their interest rate views and lock in a fixed interest coupon payment that is reflective of the client’s risk tolerance level. It is important to note that the client was also aware of the initial margin requirement of the interest rate swap, as well as the potential for mark-to-market fluctuations. A sufficient collateral buffer was earmarked to support this interest rate hedge until its maturity.
Implementation Strategy for hedging liabilities
Within the context of a borrower’s personal situation and appetite for risk, there are a number of hedging strategies that can be considered. Interest rates hedges should be considered as an integral part of real estate financing transactions or fixed income portfolios. In many cases, certainty of interest rate expenses (achieved by putting on a hedge) far outweighs the potential benefits which may come by keeping the positions unhedged. This certainty means the borrower has one thing less to worry about on their investment. Key considerations while deciding on a particular strategy include:-
- Hedge Ratios: The optimal hedging percentage and tenor of a hedge depends on the borrower’s underlying business and cash flows, as well as the borrower’s objectives and risk tolerance. These should all be reflected as part of any decision to hedge.
- Timing of Hedge: It is important that a hedge is completed when the loan has been disbursed, or if done prior to the disbursement, there is no uncertainty whatsoever on the size of the loan that will be disbursed, and its repayment schedule once disbursed.
- Type of hedge: Interest Rate Swaps, Caps and Collars are the main hedging instruments. The choice of hedge instruments should be aligned to the underlying business, and prevailing market conditions.
a. Interest Rate Swap [vanilla or forward-starting]: Borrowers can lock in a fixed interest rate (versus the variable rate that is associated with their liabilities) for a set period of time by agreeing to pay a fixed rate of interest in exchange for receiving a floating rate of interest. Effectively, this synthetically converts a floating rate liability into a fixed rate liability. This strategy is fully customizable to match the floating rate liability. The swap can start on a spot basis or a forward starting basis to suit the requirements of the borrower. If the loan is to be repaid prematurely, then this hedge will need to be unwound at the prevailing market rate. This strategy has the disadvantage of a high opportunity cost in the case where the interest rate remains low or becomes even lower after putting on the hedge.
b. Cap: A cap is an insurance like instrument and protects borrowers from interest rates going above a chosen level, allowing borrowers to take advantage of prevailing lower rates in case rates do not increase. The Cap can be unwound at no further costs in case the borrower decides to pay the loan prematurely. However, a premium is required to be paid for a Cap hedge. A cap is fully customizable to match the floating rate liability.
c. Collar: A Collar is a hybrid between an Interest rate Swap and a Cap hedge and fixes the interest rate costs between the chosen boundaries. In this strategy, a borrower is purchasing a cap and simultaneously selling a floor on a reference floating rate in the same tenor. The cost of the cap can be partly or fully offset by selling the floor. This strategy allows the borrower to participate in declining rates as long as the reference floating rate does not fall below the floor strike. For periods where the reference rate sets below the floor strike, the borrower will pay the difference to JP Morgan, foregoing the benefit of rates falling below the strike of the liability.
Employing prudent leverage or using the current historically low rates to fix existing borrowing costs has seldom been this attractive. Within the context of a client’s overall balance sheet, leverage can help to monetize assets, and provide the liquidity to achieve personal or business objectives. In the same way as we work closely with our clients on the management of their investment assets, we would also stress the importance of the active and dynamic management of our clients' liabilities. Every client situation is unique, and our JP Morgan Lending Advisors are on hand to conduct balance sheet reviews with our clients.