AG LENDING IN A CHANGING MARKET: RISING INTEREST RATES, SHIFTING POLICY, AND STRATEGIES TO COMPETE ERIC DONOVAN MANAGING DIRECTOR, INTL FCSTONE MARKETS, LLC
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Why The Yield Curve Matters
Why The Yield Curve Matters A simple plot of short, medium and long term rates
Why The Yield Curve Matters A simple plot of short, medium and long term rates What does the slope tell us about current conditions?
Why The Yield Curve Matters The current yield curve is considered flat The market is pricing in a few more hikes over the next 18 months Followed by long term rates holding steady around 3% In theory, the cost of locking in a long term rate is low: the difference between a 5 and 30 year Treasury Bond is only 26 bp s! (2.82% vs 3.08%)
Why The Yield Curve Matters What Determines Long Term Rates? The Fed?
Why The Yield Curve Matters What Determines Long Term Rates? The Fed? Global Supply & Demand For USD Bonds * Borrowers, Investors, Speculators * U.S. Treasury Bonds, LIBOR Debt & Derivatives
Shaping The Yield Curve So, coming full circle: The Fed lends the bank money at an overnight floating rate The bank lends its customer money for a project at a 20 year fixed rate The bank trades with a speculator to swap his fixed for floating cash flows The speculator does an offsetting swap with a corporation who want to switch some of his bond debt to a floating rate. MAKE SENSE???
The Cost of Funding In the short term, Farm Credit issues debt well below LIBOR. Farm Credit looks more like a government rate in the short term (Treasuries or Fed Funds)- why?
The Cost of Funding Now look what happens on the 5 year loan horizon Farm Credit rates start to tick much higher than Treasuries, and even higher than LIBOR How can the market consider Farm Credit debt about the same as Treasuries for one year but higher than LIBOR at a 5 year tenor?
The Cost of Funding Now 30 years- what is happening to Farm Credit rates? The 30 year Farm Credit rate is now about 60 bp s above Treasuries Also notice LIBOR actually falls below Treasuries- what is happening?
The Cost of Funding Where does the cash come from? 3 Types of Lenders: Banks: Alternative Lenders (mostly insurance & pension funds) Farm Credit: borrow from their depositors to make loans take in premiums and put the money in a wide variety of interest yielding investments, including ag lending raise capital by issuing bonds into the public debt markets
The Cost of Funding Where does the cash come from? 3 Types of Lenders: Banks: Alternative Lenders (mostly insurance & pension funds) Have a long-term / short-term problem Have different risks than a lender- often willing to lend at low long term fixed rates to match liabilities Farm Credit: Significant funding advantage
The Cost of Funding The cost of prepayment- Treasuries and LIBOR rates are 100% non-callable, however Farm Credit bonds can often be paid early at the issuer s option Loans and bonds that can be paid off early without any penalty have a much higher coupon. Think about it from the investors perspective, if they lend at 4.00% and rates fall to 2.00%, what happens?
The Cost of Funding Is it more difficult to compete on rates in the short term or long term?
The Cost of Funding From the borrowers perspective, does it ever make sense to forfeit your right to prepay the loan?
The Cost of Funding As rates rise, how does demand shift in ag lending? Fixed vs floating? Yield curve + prepayment spread
Impact of Rising Rates Wh?
Impact of Rising Rates Wh? What is the value of early termination when floating LIBOR was 0.19%? Farm Credit lenders have not faced this issue for the last 9 years
Private Lender Playbook How do private lenders compete for credits? 1. Take more risk 2. Win on terms
Private Lender Playbook Pairing Interest Rate Derivatives Swaps contract used to convert a floating LIBOR rate to fixed Caps & Floors similar to put or call options on LIBOR Swaptions used to create opt-in or opt-out clause at a predetermined date in the future
Private Lender Playbook How do private lenders compete for credits? 1. Calendar: The 9.5 year fixed rate
Private Lender Playbook How do private lenders compete for credits? 1. Calendar: The 9.5 year fixed rate The 15 year loan with 7 year swap
Private Lender Playbook How do private lenders compete for credits? 1. Calendar: The 9.5 year fixed rate The 15 year loan with 7 year swap Irregular amortizing schedules
Private Lender Playbook How do private lenders compete for credits? 1. Calendar: The 9.5 year fixed rate The 15 year loan with 7 year swap Irregular amortizing schedules 15 year loan with a 3 year fixed rate
Private Lender Playbook How do private lenders compete for credits? 1. Calendar: The 9.5 year fixed rate The 15 year loan with 7 year swap Irregular amortizing schedules 15 year loan with a 3 year fixed rate The fixed rate operating line
Private Lender Playbook How do private lenders compete for credits? 2. Fee Switching: The bank offers a highly competitive loan but pairs it with a swap, or another product, where fee s are captured Example: LIBOR + 0.75% with a 10 year swap at 5.00% or LIBOR + 4.00% with a 10 year swap at 1.75%
Private Lender Playbook How do private lenders compete for credits? 3. Overly Complex Terms: 15 year loan with a fixed rate, borrowers option to convert to floating after 5 years, with a minimum interest rate of 4.50% and a prepayment closeout penalty of the greater of $250k or the market value of the loan The lender is embedding 4-5 derivatives into the loan.
Private Lender Playbook Key Points Oddball loan terms usually reduce the top line rate offer, making it appear more attractive The borrower is giving something up, the exact amount of which can be calculated by a derivatives trader. Its important to point out the cost of funds advantage Farm Credit has. We need to compare apples to apples on loan terms
Future Outlook
Future Outlook Current markets are discounting the FOMC forecasts by 60-80 basis points Derivatives markets are very cheap right now Fed Market
Future Outlook Five more FED hikes in the next 2 years Increasing spread on prepayment Increasing competition on loan terms
Future Outlook Five more FED hikes in the next 2 years Increasing spread on prepayment Increasing competition on loan terms
Closing Remarks 3 Points You Must Communicate Farm Credit has lower capital costs
Closing Remarks 3 Points You Must Communicate Farm Credit has lower capital costs Private lenders can t compete in the long run
Closing Remarks 3 Points You Must Communicate Farm Credit has lower capital costs Private lenders can t compete in the long run Loan terms have a large (and growing) impact on rates
Closing Remarks The End of LIBOR LIBOR will be replaced by SOFR by 2021
Closing Remarks The End of LIBOR LIBOR will be replaced by SOFR by 2021 Better benchmark for Farm Credit funding
Closing Remarks The End of LIBOR LIBOR will be replaced by SOFR by 2021 Better benchmark for Farm Credit funding Very orderly transition
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