Higher Percent Solutions

FINANCE

Preparing for a rising interest rate environment

By Tracy Barbour

nterest rates rose in May for the second time this year. The Federal Reserve (Fed) bumped its benchmark federal funds rate 0.5 percent to a target range of 0.75 to 1 percent. The nation’s central bank applied a quarter-point-rate increase in March and has indicated that it intends to raise rates after each of its five remaining policy meetings in 2022. The Fed also announced plans to reduce its nearly $9 trillion asset portfolio of Treasury and mortgage securities, and it is allowing bonds to mature without reinvesting the proceeds into new securities. The recent moves are designed to curb record-high inflation, which surged to 8.5 percent in March—its highest level since December of 1981.

Mark Edwards
EVP, Chief Credit Officer & Bank Economist at Northrim Bank Northrim Bank

Escalating interest rates is one of today’s most important economic issues, according to Mark Edwards, chief credit officer and bank economist at Northrim Bank. “The Alaska economy showed broad improvements in 2021 and the first quarter of 2022 as it rebounded from the pandemic lows of 2020,” he posted on April 29 in Northrim’s Alaskanomics blog. “A steady recovery of jobs in nearly every sector resulted from improved tourism, rising oil prices, a strong housing market, and consumer liquidity from government stimulus programs. We believe that the potential effects of rising interest rates, high inflation, and supply chain disruptions are the most pressing issues facing the economy in 2022.”

Businesses have been expecting the effects of a higher-rate environment. As of April 19, 2022, the Federal Open Market Committee (FOMC)—the Fed’s policy-making arm—was projecting Fed funds target rates to increase 2.75 percent in the next twelve to eighteen months, according to Wells Fargo Securities.

“Long-term, fixed rates have increased more than short-term rates in anticipation of projected Fed funds rate increases,” says Sam Mazzeo, who leads Wells Fargo’s Alaska Commercial Banking Group. “Ten-year, US Treasury Bill yields have already increased 1.4 percent from 1.5 percent at year-end [December 31, 2021]. Ten-year US Treasury Bill yields are currently 2.9 percent, as of April 19, 2022. Banks often tie fixed rates directly to US Treasury Bill yields, which are also a great barometer of interest rate swap costs.”

Effects on Obtaining Loans

Banking customers will feel the immediate pinch of the higher interest rates with lines of credit, which are attached to the prime rate, says Chad Steadman, a senior vice president and senior corporate lending director at First National Bank Alaska. However, in the last couple of years, many businesses have accumulated enough cash that they don’t need to access their lines of credit. “Many businesses have paid down their debt and are in a cash position,” he says. “We have had businesses that have closed their lines of credit because their cash is so strong.”

Consequently, the demand for smaller loans has waned; when companies do borrow, it’s for larger purposes, such as a real estate purchase. “Most of our businesses report that business is up,” Steadman says. “Many of the businesses can handle the higher interest rates.”

Depending on the financials involved, higher interest rates can significantly affect a company’s ability to secure loans. A higher interest rate results in a higher payment that borrowers must prove they can afford. “The best way to counteract that is to have a solid plan of how you’re going to repay the loan,” Steadman says. “The bank wants to see good balance sheet strength.”

Essentially, higher interest rates affect profit, cash flow, and the ability to amortize debt. This makes higher leverage less affordable for borrowers. “Today, borrowers are more concerned with hedging interest rates related to future borrowing needs compared to one or two years ago,” Mazzeo says.

Sam Mazzeo
Head of Wells Fargo Alaska’s Commercial Banking Group Wells Fargo

Should current conditions change borrowers’ approach to commercial financing? Mazzeo’s recommendation is for borrowers to maintain a mix of fixed- and adjustable-rate debt, and they should consider the amount of interest rate risk their business can afford. For example, a company operating on a narrower margin with less pre-tax cashflow cannot afford to take much risk and may need to lock in an interest rate for a longer term.

Since higher interest rates translate into larger loan payments and influence a company’s access to capital, business owners must be precise when seeking financing, says Tracy Morris, a senior vice president of commercial lending at KeyBank. “It is imperative that business owners be strategic in debt structures and fully understand sales cycles and capital needs,” she explains. “Hedging interest rates is an option that should be considered.”

How to Prepare

Rising interest rates make financial and operational environments more challenging, but having sound decision-making and a proactive strategy can help companies better prepare themselves.

To mitigate the volatile climate, businesses might want to keep cash on hand for future projects. While rates are lower, they could consider financing assets—even if they have cash on hand and don’t actually require financing. Steadman explains: “It’s a great time to do an inventory analysis of your balance sheet. See what assets you need to replace now while we’re still in a good rate environment. Historically, commercial rates have been 6 to 8 percent. The last two years, they have been in the 3- to 4.5-percent range, depending on the borrower’s collateral and situation. To expect them to stay that way is not reasonable.”

Tracy Morris
SVP, Commercial Banking at KeyBank KeyBank

In addition, companies with upcoming debt maturities that qualify for long-term financing should consider extending maturities on credit lines and loans. Borrowers should consider longer-term fixed rate or interest rate hedging contracts provided by interest rate swaps. “Borrowers with defined long-term capital needs in the next eighteen months may hedge interest rates related to future borrowing needs with forward rate lock contracts provided by interest rate swaps,” Mazzeo explains.

Mazzeo says businesses with growth opportunities need enough credit to provide flexibility. “Borrowers with lower leverage and excess liquidity may view rising rates as an investment opportunity,” he says. “The Fed is trying to reduce inflation and asset prices by increasing interest rates. This can provide better buying opportunities for those companies positioned with cash and lower leverage going into a rising-rate environment.”

Ultimately, companies should “run their businesses and then manage interest risk” around that, Mazzeo says. “My theme is being proactive: looking out a couple of years, determining what their debt needs will be, and proactively managing debt in that fashion,” he says.

“We had one of our best years last year, even though we did fewer loans.”

Chad Steadman
Senior Corporate Lending Director
First National Bank Alaska

Insulating against rising interest rates can be difficult. One of the best ways to accomplish this is with an owner-occupied property. Companies that are paying rent should consider owning their property and effectively locking in their rate, Steadman says. “After that, it becomes very difficult to protect yourself,” he adds. “You could finance your equipment, but that would provide a locked-in rate for just three to seven years, depending on the asset’s expected use.”

Businesses also should carefully consider the term and duration of their loans. The goal is to lock in fixed interest rates over the long run—five or ten years—to stabilize their exposure to rising interest rates, Edwards says. He also suggests looking at a fixed interest rate swap for products the business will buy and hold for the long run and securing a line of credit. A credit line will afford companies access to working capital during times they might be churning their business cycle. “A line of credit provides liquidity when you need it,” he says. “It can be helpful when you’re facing uncertain times.”

It would behoove businesses to cultivate a relationship with a financial institution that has expertise on various state and federal lending programs. The lender may be able to use these programs to facilitate a favorable fixed-rate loan, such as a twenty-five-year, fixed-rate option from Alaska Industrial Development Export Authority. “When your business gets fixed-rate loans, you can know what your payments are for the foreseeable future; you can have more certainty during rising rates,” Edwards says.

Morris’ prescription for preparing for an environment with rising rates is to collaborate with financial partners. Business owners should review their balance sheet to see how much variable debt they have and if it is time to convert to a fixed rate. “Companies should also consider how much cash they have on hand with respect to the impact of anticipated interest rates rising,” she says.

Strong Commercial Loans

Commercial lending activity is robust in Alaska. At First National, the demand for smaller loans has been lower because businesses have ample cash on hand, but the transaction sizes have been relatively larger. “We had one of our best years last year, even though we did fewer loans,” Steadman says.

At this point, Steadman expects commercial lending to remain strong. Regardless of the interest rates, companies continue to borrow as long as it makes good business sense. If rates dramatically increase this year, commercial activity may diminish.

Commercial lending is also strong at Northrim Bank, which had record activity during the last two years. Consequently, the community bank has been significantly growing, adding production offices in Nome and Kodiak, a second branch location in Fairbanks, and many new customers statewide. “We’re a well-capitalized bank with strong deposits; we have money to lend,” Edwards says.

The demand for commercial loans also has increased for Wells Fargo, overall and in Alaska. In 2021, demand was lower, but there has been a noticeable increase in demand and activity in 2022, Mazzeo says. “Our Alaska Commercial Banking team does a lot of work with Alaska Native corporations, which have continued to grow their government contracting businesses,” he explains. “Many Native corporations are actively investing in new ventures and buying other companies, which provides new financing opportunities. We are actively lending to oilfield services companies in Alaska, Alaska commercial fishing companies, mining support companies, and tourism-related companies, among other industries in Alaska.”

What to Consider

What should Alaska companies keep in mind as the year progresses? Businesses are eager to use available cash, and as the higher interest rates affect the cost of capital, businesses should evaluate their debt structure, Morris says. Additionally, companies need to focus on supply chains, rising inflation, and the highly competitive labor market. “Now might be a time to discuss with your financial institution the option to convert variable rate financings to fixed rate,” she says.

From Steadman’s perspective, Alaska businesses should concentrate on the right asset mix and balance sheet strength. “We’ve seen a lot of people who have let their line of credit lapse, which doesn’t surprise me,” he says, “but with the uncertainty in the market, they may want to speak with their banker now about getting a line of credit instead of waiting until the need arises.”

In terms of advice for how to approach the months ahead, Mazzeo cautions: “Do not panic regarding rising interest rates, as rates can be managed, but make sure you are proactive to manage business debt. Business debt is a tool, which, used appropriately, can allow your business tremendous flexibility to operate and grow more efficiently.”

Companies could also benefit from assessing their non-performing assets. They should review their balance sheet and ask, “Do I really need to own this?” They might decide to sell their building and lease it back or sell equipment they no longer need—which could be advantageous since prices are higher now. “Good management decisions will determine your results in difficult times,” Edwards says. “You have to be more active in your management… You have to be nimble and adjust.”

Chad Steadman
SVP, Commercial Lending Director at First National Bank Alaska FNBA

Edwards also highlights that with the instability caused by supply chain problems, Russia’s war against Ukraine, and the pandemic, more people are questioning the source and reliability of goods, and that’s good for the Alaska economy. “If we can develop and produce natural resources here and goods are reliably sourced, that’s the silver lining,” he says. “Maybe there will be more attention on Alaska-sourced products.”

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