Managing Risks in a Rising Interest Rate Environment
Since late 2007, the Federal Reserve (Fed) has used aggressive measures to keep interest rates low, inflate asset prices and stimulate the economy. Even though the Great Recession officially ended in September 2009, these monetary policies effectively remain in place today. Recently, however, the narrative has shifted from “if” to “when and how aggressively” rates will rise. Nonprofit organizations with investible assets and long-term debt should view this as an opportunity to manage interest rate risk.
Interest Rates Should Rise . . . Eventually
Fed policy and world events have resulted in historic lows for both short-term and long-term interest rates over an extended period. The capital markets, with guidance from the Fed, are now anticipating a deliberate approach to raising the Fed Funds rate—beginning with an increase from the current level of 0% to 0.25%. Contemporaneously, there is an expectation for long-term rates to increase as well, reflecting an improving economy and mild inflation.
Many nonprofit organizations have embraced the ability to borrow during this time of low interest rates. Confronted with the likelihood that interest rates will be higher in the future, borrowers should review whether or not existing policies and procedures for managing interest rate risk are being followed. If guidelines are silent on the matter, a plan suitable for the organization’s long-term goals and objectives should be swiftly adopted.
Asset-liability management is a critical component of financial risk management. Despite the relationship between these components of the balance sheet, organizations often manage assets and liabilities without any consideration of the other. A systematic approach of integrating debt and investment policies helps organizations avoid many adverse consequences (e.g., diminished access to capital, higher borrowing costs, or limited liquidity) that compromise the ability to fulfill the mission.
A sound investment policy expressly states objectives while taking into account an organization’s overall obligations, including liquidity requirements and spending policy. The investment policy should implicitly align the mission, objectives and all policies of an organization while explicitly referring to any outstanding debt obligations. Ideally, the implicit portion would survive the natural turnover of committee and board members. However, any aspect of the investment policy related to debt should be revisited regularly and, if appropriate, revised to reflect any modifications in structure and terms.
Nonprofit organizations have access to capital from five sources. Internal sources include operations (free cash flow after debt service), monetization of assets, and existing cash and investments. External sources include benefactors and debt. Debt provides the most immediate access to significant sums. As such, nonprofits must establish, maintain and protect a strong credit profile.
A debt policy sets forth guidelines an organization uses to govern the amount and types of debt to which it will become obligated. Effective implementation considers industry standards and market dynamics as well as the actions necessary to realize the dual objectives of low cost and maximum flexibility. Factors should include: impact on credit rating, overall capital planning, affordability, borrowing capacity, use of cash, length of debt, type of structure, variable rate exposure, use of derivatives, refinancing, credit enhancement, method of sale and investment of proceeds.
A well-conceived asset-liability management plan provides guidance in any rate environment. Unfortunately, it is often disregarded when interest rates are low and credit is widely available. Furthermore, operational discipline fades with reduced borrowing costs and healthy investment gains, putting greater reliance on access to cheap capital.
Interest Rate Risk Management Strategies
Comprehensive debt policies inherently contain guidance (e.g., affordability, capacity, term, structure) for managing interest rate risk. Furthermore, rating agencies and the capital markets provide additional advice (e.g., net variable rate exposure should not exceed 25% of all outstanding debt). The following are some of the more common mitigation techniques:
Long-Term, Fixed-Rate Financing
Probably the most traditional method utilized by nonprofit organizations is the issuance of fixed rate bonds. However, while this method fixes borrowing costs, it also “locks in” a borrower’s credit profile. Thus, if the credit profile subsequently improves, significant costs would be incurred should the borrower want to restructure its debt to realize a lower rate.
Some programs, such as those administered by the U.S. Department of Housing and Urban Development (HUD), do not have risk adjusted pricing. Thus, if a borrower qualifies, there is a strong incentive to pursue this financing option. HUD happens to be a very attractive alternative for those organizations seeking nonrecourse, low-cost, fixed rate permanent debt without financial covenants—especially when there is consensus that interest rates will rise.
Another consideration for longer term debt is the challenge of realizing low-risk interest rate arbitrage. Historically, nonprofit organizations had an opportunity to achieve tax-free investment returns in excess of borrowing costs. Match funding at the short end of the yield curve usually offers the best opportunity for arbitrage. Seeking investment returns in excess of borrowing costs at the long end of the yield curve should be addressed in the investment policy as match funding is generally not feasible and potentially exposes the organization to greater risk.
Mid-Term (Five-, Seven-, and 10-Year) “Fixed” Rate Debt
Mid-term debt is a common funding structure wherein bonds are directly purchased by a commercial bank. However, it should be noted the debt is not as much fixed as it is subject to reset in the future. As such, borrowers are exposed to renewal risk in the form of both interest rate (overall market rates) and credit (a weaker financial profile or less appetite in the market for its sector). This option should be viewed relative to the overall economic cycle, rate expectations and existing credit profile.
Variable Rate Debt with a Fixed Payor Swap
This is another method of funding wherein debt, which is reset weekly or monthly, is directly placed with a commercial bank. The borrower manages its variable rate exposure through a swap agreement by exchanging obligations with a counterparty that accepts variable rate risk while the borrower makes a fixed payment for the term of the contract (Figure 1).
Swaps are generally for the same term as mid-term “fixed” rate debt. As such, borrowers have the same renewal risks listed above. Furthermore, borrowers are often frustrated when interest rates do not rise after executing a swap. This perception of having paid more than was necessary characterizes the risk mitigation effort as a trade. As such, borrowers are encouraged to document the reason for entering into such a structure (e.g., following asset-liability management plan) in order to reduce the effect of buyer’s remorse.
Variable Rate Debt Naturally Hedged
Naturally hedging variable rate debt means match funding investible assets with the debt. Historically, nonprofit borrowers could rely on this strategy to mitigate interest rate risk and even present an opportunity to realize interest rate arbitrage. That is, the nonprofit organization borrows at tax-exempt rates while investing at higher taxable rates. The debt is “naturally” hedged. Counterintuitively, higher borrowing costs (i.e., increase in short-term rates) creates opportunities for greater investment returns. With taxable rates near zero—as is the present case—there is no interest rate arbitrage opportunity.
Variable Rate Debt Unhedged (“Buy Term, Invest the Difference”)
Some nonprofit organizations are comfortable budgeting the cost of debt at a certain level (e.g., 6%). Such borrowers will issue variable rate debt and set aside the difference. If handled with appropriate discipline (i.e., not appropriated for other purposes), these funds can be used to cover the cost of debt when it exceeds the budgeted rate.
Interest rate risk management strategies offer protection from capital market volatility. Properly structured to reflect an organization’s goals and objectives, techniques can help moderate any negative impact from rising interest rates. Furthermore, because of the difficulty in predicting the direction of interest rates, nonprofit boards should avoid evaluating strategies in isolation and measure effectiveness relative to the entire organization, especially as it relates to facts and circumstances present at the time a decision was made.
The possibility of rising interest rates should remind nonprofit organizations to review policies and procedures used to manage assets and liabilities. Implementing interest rate risk management strategies that effectively integrate debt and investments should enhance financial viability as well as ensure long-term stability. Additionally, this is also a time to review operational efficiency and address any excesses that are sustainable only with cheap debt and investment returns. The Fed has made its intentions known and the opportunity is now for nonprofit organizations to strategically plan for success in a rising rate environment.