11 May 2017 |
Interest Rate & Funding Outlook
Interest Rate Outlook
Bank economists and market pundits have been warning that interest rate rises were “imminent” for the last eighteen months. Whilst some elements of those predictions have come to fruition, the reality is that economic norms can not necessarily be relied upon as a predictor of interest rate movements because the global economy is more complex, interconnected and uncertain than it has ever been before. Even in the absence of those factors all forecasting is fraught with difficulty and, to steal a phrase, can be said to revolve around the art of saying what will happen, and then explaining why it didn't!
Nevertheless rates have been rising and are slated to rise further, but in order to understand those increases it’s worthwhile providing a short explanation of the components which make up the total cost of borrowing.
Cost of Borrowing Explained
The interest rate charged has two, or sometimes three, principal components. The first component is the bank base rate, which can be said to be strongly influenced by the the many factors which affect and determine the Offical Cash Rate (“OCR”), the mechanism through which the Reserve Bank of New Zealand seeks to control the domestic economy.
The second is the credit risk margin, which reflects bank appetite and the perceived risk within a transaction, taking into account risk metrics such as the Loan to Value “LVR, debt servicing ratio, quality of the asset, location, tenant covenant and importantly the experience of the Borrower.
The third component is a liquidity premium which is sometimes added to the base rate and sometimes included in the credit risk margin. We prefer to include the liquidity premium in the base rate. We do so as this premiuim concerns the cost of borrowing to banks, and as such it relates more to treasury management than it does to ‘riskiness’ in an asset.
Separating out these components helps to understand why rates are rising when the more easily recognised base rate, for the sake of argument the OCR, is not.
Current interest rate increases can be attributed to bank funding pressures, as opposed to New Zealand’s underlying economic performance, which would ultimately be addressed by movements in the OCR. These pressures come from two fronts; the first is that credit growth is outstripping domestic savings thereby creating a large funding gap , as illustrated Fig .1
Fig .1 Fig.2
Source ANZ Jan 2017
This funding gap causes the second pressure point and that is the need for banks to borrow more. If savings are decelerating, as the table shows, then banks need to either borrow more off-shore (as illustrated Fig .2) or compete at home to attract more domestic deposits. Both options do and have pushed up cost of funding for lenders, and it is here that rate increases are passed on to borrowers, entirely independent of the OCR. The demand for credit also creates a situation where lenders are able to more carefully select those transactions that represent the most profitable use of their available funding, allowing them to set their price, so to speak.
Market commentators all agree interest rate rises are on their way. Until recently there was broad agreement on the timing of an increase coming in mid to late 2018, but recent inflation figures have suprised markets. There hadn’t previously been much disagreement with the RBNZ’s intention to raise the OCR in 2019, but views are now diverging and, in the face of further inflationary pressure, commentators suggest the RBNZ will be unable to resist holding off rises for that timeframe.
That said the RBNZ’s May 11 Monetary Policy Statement (MPS) which left the OCR unchanged, amid a framework of undeniably neutral language, left some dealers scratching their heads; one economist suggested “the[RBNZ’s]inflation forecasts seem to be testing the realms of credibility, given an economy that is forecast to continue to grow above trend”.
Whilst consensus of rate rises remains, when, how much and how far remains to be seen, however. It’s apparent a sense of caution persists which may be due to the underlying view that seemingly fragile economic recoveries could easily be knocked off-course in what remains a very uncertain, global political environment.
A best practice approach should be adopted which deals with;
- availability of funding: an assessment of lending market conditions, current and on loan expiry (if existing);
- interest rate expectations: what are the forecast floating and fixed rate options
- funding strategies: single or multiple tranche approach
In determining an appropriate loan structure the first consideration must be whether or not the security for the loan is being retained, as there would be little point in entering into a loan for 5yrs if a property was to be sold in 12mths. The availability of funding must also be considred here as lender appetite and pricing are not consistant, and as such the required term and level of funding might not always be available.
When considering an interest rate strategy, as property is generally bought as a long term income producing investment, it is necessary to identify a structure which provides an acceptable rate of return for the holding period envisaged, whilst also protecting against rising interest rates, which would be the case if loan facilities remained wholly exposed to floating rates, which quite rightly have been the preferred option over recent years.
To provide for the greatest range of interest rate structures the term of the loan facility, or facilities under a multi-tranche strategy, needs to be as long as possible. Generally speaking banks will provide a loan term of up to 5yrs, and/or which does not exceed the unexpired term of the contracted cash flow, which itself is determined by the lease agreement/s for the property. If lease terms are short it may simply not be possible to negotiate a longer loan term, but where possible, and despite any exisiting loan arrangements, consideration should be given to extending the loan where possible and appropriate.
But before approaching your lender, other questions must be addressed. For example if a borrower were to negotiate a new loan now, in the market conditions described in this note, they could potentially be exposed to an increase in the credit risk margin, a higher base rate and liquidity cost, as as at negotiation all commercial terms are up for review, so these risks need to be balanced with funding certainty and structure.
Treasury management is an ever present requirement however in light of the increasing likelihood of further interest rate rises, over the short to medium term, we believe the timing is now right to give considered thought to the term and structure of current loan facilities. Over the next quarter the Anaro team will be considering these questions and, where relevant, will report back to our partners with our findings and recommendations.
GM, Anaro Investment Group