Finance Teams Prepare for Higher Rates

Companies issue bonds now, locking in lower interest rates, as Fed embarks on tapering.

The Federal Reserve’s December announcement that it will begin decreasing the amount of securities it buys in its quantitative easing program this year points to a continued increase in long-term interest rates. But with economists expecting economic growth to be as good as last year’s or better, the higher rates aren’t expected to discourage companies from issuing debt.

At the end of 2013, the 10-year Treasury bond rate stood at 3.04 percent, up from 1.78 percent at the end of 2012. Milton Ezrati, senior economist and market strategist at Lord Abbett, an asset management company in Jersey City, N.J., expects long-term Treasuries to rise another 100 basis points this year.

The Fed is likely to be “less aggressive” about tapering its purchases given the weaker-than-expected December employment report, Ezrati said. “That means rates will probably do more of their rising later rather than earlier. But we do think rates are going to move up.”

Short-term rates are still extremely low, though, with the Treasury three-month bill at 0.05 percent, and they’re are likely to remain low given that the Fed isn’t expected to raise the fed funds rate until 2015. “That’s a very important distinction,” Ezrati said. “The short end is the area where the economy is more sensitive.”

Corporate finance teams have been making the most of lower rates while they can. According to a survey of 424 finance executives conducted by the Association for Financial Professionals (AFP), 55 percent said their company took at least one action in 2013 to take advantage of the low-interest-rate environment. Fifty-five percent of those who took action refinanced long-term debt, while 52 percent issued long-term debt, 36 percent renewed a revolving credit facility early, and 28 percent locked in rates with swaps or options.

“Everyone knew that at some point rates had to go up,” said Kevin Roth, the AFP’s director of research. “As a result, financial professionals began to lock in these low rates.”

The AFP survey was conducted in early December, before the Fed announced its tapering, and two-thirds of the respondents said they expected little change in borrowing costs this year. Almost half (49 percent) said their company plans to take some action this year based on their expectations for interest rates.

Again the most popular plan, cited by 42 percent of those whose company plans to take some action, was to refinance long-term debt, while 37 percent said they will reduce their outstanding debt. And many cited plans to issue long-term debt for various purposes: 36 percent to finance an increase in capital expenditures, 18 percent to finance mergers and acquisitions (M&A), and 9 percent to purchase stock.

The talk of debt issuance comes on the heels of two years in which corporates increased their issuance of bonds. Last year, U.S. companies issued $1.07 trillion in new debt, up from $1.04 trillion in 2012, according to Standard & Poor’s Corp.

Diane Vazza, director of global fixed-income research at Standard & Poor’s, expects issuance to be flat to a little higher this year. “You’re coming off a very high level,” Vazza said. “Even flat is healthy issuance.”

She estimated that two-thirds of the issuance over the last two years was refinancing and said some companies will still be refinancing this year, particularly speculative-grade companies. S&P data show U.S. companies still have significant amounts of debt maturing over the next few years: $1.4 trillion in 2015 and $1.2 trillion in both 2016 and 2017.

“We think what’s going to take up the slack as we see less refinancing in 2014 is investment in business,” Vazza said.

That’s all against the background of a gradual increase in long-term rates. “Not a pop,” Vazza noted. “That would choke issuance.”

John Cryan, a partner at Fortuna Advisors, said that while finance theory suggests rising interest rates discourage businesses from investing and borrowing, companies consider the state of the economy as well as rates. “If interest rates are rising because of positive signs, and not because of increased risk and fear, you’ll probably see higher investment than would be assumed using a pure quantitative model,” Cryan said.

“I’m a bit optimistic on this,” he added. “I think rising interest rates in the near term will increase investment, not decrease investment, even though it will cost slightly more.”

Another aspect of rising rates is the possible effect on customers, Roth said: “Companies obviously need to be concerned about the demand for their products. Especially for companies that sell directly to consumers, they have to see how demand for their products will be affected if rates go higher.”

Two sectors that are sensitive to interest rates—housing and autos—were “fairly resilient” last year, Roth said. “One of the things that will be interesting to see is whether demand for goods and services will continue to grow even as the cost of borrowing increases.”

 

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