Interest rates have reached an inflection point. For most of the past decade, the U.S. Federal Reserve has kept the federal funds rate near zero, resulting in extremely low rates on everything from corporate borrowing to bonds to mortgages.
The Federal Reserve has increased rates three times since December, and analysts expect rates to keep rising gradually amid a strengthening U.S. economy. This could mean higher costs as well as opportunities for many companies.
Here are five suggestions for how midsize businesses should react to rising rates.
Identify The Reason For The Rise
Not all rising rate environments are the same, so companies need to understand why rates are going up and react accordingly. For example, if interest rates are rising because the economy is improving, access to capital shouldn’t be an issue. However, an event-driven rise in rates, such as an economic calamity, could affect the availability of credit.
“If you see clouds on the horizon, shore up your company balance sheet and/or pull back on some of your spending to ensure you have the capital and cash flow you need to run your business,” said Michael Skordeles, director of U.S. macro strategy and senior vice president at SunTrust Advisory Services.
The speed at which interest rates rise, as well as basic recession flags — such as a rise in the weekly initial jobless claims — should also govern how companies react.
“The worst bear markets that have inflicted the biggest losses were driven by inflation, so watching over recessions is as important as anything else,” Skordeles said.
Evaluate Your Specific Risks
The risk of rising interest rates can’t be evaluated in a vacuum, but must be considered as part of an appropriate risk management plan based on each company’s particular situation and risk tolerance, according to Jeff Messner, managing director in financial risk management at SunTrust Robinson Humphrey. “Rather than look for a one-size-fits-all hedging strategy, you identify the things that are putting the company at most risk,” he said.
For example, a midsize company that sources a lot of products from Europe might need to safeguard against currency risk. That wouldn’t be a significant issue for a company whose entire business is conducted within the United States.
Skordeles said the first three questions any business should consider as it develops the right mix of safety, liquidity and yield are:
- What am I trying to accomplish?
- What are my time horizons?
- What mix of risk is going to allow me to sleep at night as a business owner?
Be Aware Of The Float
Many midsize companies have borrowed based on a floating rate, whether from a bank or via a floating rate bond.
“It’s easy to have grown complacent because there hasn’t been a lot of volatility in floating rates over the past decade,” Messner said. “This is something you need to shine the light on again, because you might wake up and find the floating rate is 100 basis points higher.” And considering that the current base level is so low, a huge jump in basis points could have significant financial implications.
There are several strategies to neutralize volatility, such as using an interest rate swap where some of the floating rate borrowing is converted to a fixed rate. Another strategy is an interest-rate cap, where a hedge kicks in if the floating rate reaches a certain level. This carries an upfront cost, like an insurance policy.
Skordeles notes that while waiting for rates to rise, many business owners have sat on cash for significant periods of time rather than invest in bond funds or other vehicles with better returns.
“They gave up a lot in returns over the last five years, and reduced their working capital,” he said. “There is a price to waiting.”
Now, as rates rise, companies face another kind of risk in waiting: higher costs. Skordeles recommends companies lock in at lower borrowing rates.
Unfortunately, he says, the long period of low rates has made some companies complacent.
“Business owners are not getting the normal signals from the Fed that alert them to lock in rates,” he said. “Because rates are rising so gradually, business owners face the prospect of being the frog in the boiling pot.”
Tune Out The Noise
A period of rising rates can be chaotic. During these periods, people are often flooded with contradictory advice, which Skordeles says can lead to knee-jerk reactions, such as the wholesale dumping of bonds.
“One of the biggest mistakes you can make is listening to everyone and everything,” he said. “Identify a few trusted media sources and develop a relationship with an investment adviser who understands your risk tolerance and situation, and then start ignoring some of the noise out there in the world.”