Managing Interest Rate Risk in a Changing Environment
Although the interest rate environment has remained relatively consistent for the past few years, there is reason to believe that may be changing. Despite interest rates remaining very low by historical measures, any firm looking to utilize external financing for purchases this fiscal year should be aware of potential changes and possible budget implications.
Since the December 13th Federal Open Market Committee (FOMC) meeting, interest rates have accelerated their move higher. The 5-year treasury rate is up 52bps to 2.66% in just the last couple months, the highest level in 5 years.
The Updated Dot Plot
The FOMC members’ new dot plot of the median fed funds rate forecast is illustrative of the expectation for further rate increases in the months and years ahead. The current consensus is for 3 rate hikes in 2018, and continued hikes through 2020.
Source: U.S. Federal Reserve. December 2017.
Hedging Interest Rate Risk on Projects
If your firm is considering financing for critical technology upgrades or office renovation projects this year, you may be considering ways to hedge interest rate exposure. While projects come in all different shapes and sizes, there are some important questions to consider as you prioritize and evaluate your options:
1. What is your appetite for interest rate risk?
If you do not have an appetite for assuming the interest rate risk, fixing your financing cost becomes very important.
2. What are the estimated project expenses? What is the project timeline and how long will it take to complete the project?
Projects with longer implementation timelines have greater exposure to interest rate risk as the rates associated with traditional financing products are not fixed until the project is complete.
3. What financing terms are you considering?
The longer the financing term, the more sensitive your project is to increases in interest rates. A simple 25bps increase in rates on a 5-year term can increase your overall interest expense by over 6%.
As you begin evaluating project financing options, the emerging consideration of how you mitigate interest risk can provide increasing value should rates continue to climb. Hedging interest rate risk with interest rate locks or forward interest rate swap agreements may help your firm maintain budget consistency or reduce interest expense with your upcoming capital needs.