What s the Cost of Waiting? How Interest Rate Swaps May Help Manage Your Interest Rate Exposure. May 2014. Prepared by: Walt Edwards, Director, Wells Fargo Interest Rate Risk Management, Wells Fargo Securities, Associated Person. Sean T. Faeth, Private Banking Director, Wells Fargo Private Bank. In this special report 1 Where will interest rates go from here? 2 How quickly will swap rates rise? 2 Will opportunity costs become real costs? 3 The value of relationships
What s the Cost of Waiting? How Interest Rate Swaps May Help Manage Your Interest Rate Exposure. Interest rates have been low for a long, long time. We all know the reasons, and some of us may have become numb to the predictions of economists that interest rates will, in fact, begin rising within the next 12 to 18 months. Have borrowers been lulled into a false sense of security that they have ample time or will receive some sort of advance notice before interest rates climb from their lowest levels? The reality is that waiting to manage interest rate risk may have a real cost given the risks associated with the pace and extent of interest rate movements. The saying that no decision is a decision applies in this case, and no action may come at a price, particularly given that even a small increase in rates may be material relative to the currently low starting point. As such, if you have significant, unhedged loans or lines of credit, it may be worthwhile to have a conversation with a Private Banker and Interest Rate Risk Management Specialist to review your interest rate risk exposures. Where will interest rates go from here? The Federal Open Market Committee (FOMC) released its forecast of the Federal Funds target rate following its meeting in March 2014. As part of its statement, the FOMC indicated that all 17 participants expect the Fed Funds Rate to be at or above 3.50 percent in the longer run, and the median forecast of FOMC members is for a Fed Funds target rate of 1.00 percent by the end of 2015 (Chart 1). The Fed has also been reducing its asset purchases since January 2014 by $10 billion per month a down payment of sorts to future tapering. With the unemployment rate at 6.30 percent in April 2014 and just slightly below the Fed s target rate of 6.50 percent, the Fed is shifting towards qualitative criteria, revising Chart 1. Target Federal Funds Rate Forecast as of March 2014 Fed Funds Target Rate 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% FOMC Projection Median FOMC Member Projections 2014 2015 2016 Longer Run forward guidance language to state that future decisions would be based on progress towards the FOMC s goals of maximum employment and a 2.00 percent inflation rate. Given similar intimations in the past, many clients may be skeptical that the Fed is really serious this time around. Others may assume that any rate increase will be gradual, with plenty of advance notice on any short- or long-term rate increases. It is important to note, however, that swap rates have historically risen often precipitously in advance of the first Fed Funds rate hike. In fact, during the most recent monetary policy cycle, long-term rates consistently increased as the Fed hiked short-term rates from 2002 2006 (Chart 2 on the following page). Over this cycle, the Fed held the target rate flat for 12 months before increasing it 425 bps in the following 24 months. While the market sold off too soon in some cases only to rally prior to the first increase in the Fed Funds target rate, swap rates moved consistently higher following the initial target rate hikes. Have borrowers been lulled into a false sense of security regarding low interest rates? Borrowing on a floating-rate basis and using a separate transaction, such as a swap, cap, or collar, to hedge against interest rate risk may have advantages not found with typical fixed-rate loans. Three potential benefits of an interest rate swap. 1 Interest rate stability in hedging interest rate risk associated with floating rate loans. 2 Flexible risk management including terms, portability, early loan termination or prepayment. 3 Potential for no upfront, out-of-pocket cash payments. May 2014 What s the Cost of Waiting? How Interest Rate Swaps May Help Manage Your Interest Rate Exposure 1
This pattern was also apparent in the two earlier Fed tightening cycles from 1985 1990 and 1992 1994. With Fed Funds at 0 0.25 percent for the last five years, there is the potential for a tightening cycle of a meaningful magnitude once the Fed begins its campaign. Chart 2. Fed Monetary Policy Tightening from 2002 2006 Rate 5.75% 5.00% 4.25% 3.50% 2.75% 2.00% 1.25% 0.50% 2002 2003 2004 2005 3-Year Swap 3-Month LIBOR Fed Funds Target Rate How quickly will swap rates rise? Given that many economists expect that market interest rates will begin moving prior to the Fed Funds rate hikes predicted between now and the end of 2015, it is reasonable to think that rising swap rates may not be so far off. So the question for many borrowers may be not if but rather when to hedge interest rate risk exposures. In addition, recent examples of rate volatility indicate that any long-term rate increases could be fast moving. For example, less than one year ago, following 2006 a string of positive economic reports and former Fed Chairman Ben Bernanke s statements to Congress that the Fed s tapering of asset purchases could begin in a matter of months, the 10-year swap rates rose in a meaningful way (Chart 3). Although swap rates pulled back somewhat in late 2013, there are no guarantees of future pullbacks once swap rates start rising. Chart 3. 10-Year Swap Rate (January 2013 January 2014) Swap Rate 3.3% 3.1% 2.9% 2.7% 2.5% 2.3% 2.1% 1.9% 1.7% 89 Basis Points increase since May 2013 1.5% 01/13 03/13 05/13 07/13 09/13 11/13 01/14 Will opportunity costs become real costs? Quantifying potential sensitivity to changes in interest rates always depends on a borrower s financial situation. As an example, consider interest rate sensitivity for a $5 million loan with a five/25 year tenor and $5 million notional swap (Table 1). The analysis below is based on a comparison of one-month LIBOR to fixing LIBOR at recent mid-market swap rates. In this example, the Table 1. Hypothetical $5 Million Loan with a 5/25 Year Tenor and $5 Million Notional Swap $5 million loan with a 5/25 year tenor and $5 million notional swap One-month LIBOR (London Interbank Offered Rate) vs. Swap Rates as of April 15, 2014 Average Annual 1ML (1SD) Fixed Swap Rate Annual Interest Savings (Expense) in % Annual Interest Savings (Expense) in $ Cumulative Interest Savings (Expense) in $ 0.24% 2.56% 2.32% $116,000 $116,000 Year 1 0.82% 2.56% 1.74% $85,206 $201,206 Year 2 2.03% 2.56% 0.53% $25,379 $226,585 Year 3 3.21% 2.56% (0.65)% ($30,385) $196,200 Year 4 4.13% 2.56% (1.57)% ($71,511) $124,689 Year 5 4.76% 2.56% (2.20)% ($97,438) $27,251 Year 6 5.12% 2.56% (2.56)% ($109,995) ($82,744) Year 7 5.39% 2.56% (2.83)% ($117,660) ($200,405) Year 8 5.53% 2.56% (2.97)% ($119,139) ($319,544) Year 9 5.65% 2.56% (3.09)% ($119,204) ($438,748) Year 10 Source: Wells Fargo Interest Rate Risk Management, 04/14 2 May 2014 What s the Cost of Waiting? How Interest Rate Swaps May Help Manage Your Interest Rate Exposure
opportunity cost of waiting to hedge interest rate exposure could become quite significant over $100,000 per year depending on market interest rate movements. The value of relationships. Developing a hedging strategy in advance of potentially rising interest rates may be prudent, particularly as the current interest rate cycle appears to be waning. Any considerations start with conversations that focus on your individual needs and circumstances. The Private Bank team will first seek to understand your current situation and objectives, and then work with you to explore alternatives that may help manage interest rate risk and potentially lower borrowing costs depending on marketplace conditions. Five questions to consider regarding interest rate exposure: 1 How much long-term credit do you have and what portion is fixed vs. floating? 2 How was the interest rate structure determined on this credit? 3 Do you have concerns about the interest rate structure on your loans? 4 Do you have loans that need to be refinanced in the next 12 months? 5 What would be the impact on your wealth plan if interest rates rose one percent or more? May 2014 What s the Cost of Waiting? How Interest Rate Swaps May Help Manage Your Interest Rate Exposure 3
Disclosures. Wells Fargo Private Bank provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries. All loans are subject to credit approval. Securities-backed lending has special risks and is not suitable for everyone. If the market value of your pledged securities declines below required levels, you may be required to pay down your line of credit or pledge additional eligible securities in order to maintain it, or the lender may require the sale of some or all of your pledged securities. The sale of pledged securities may cause you to suffer adverse tax consequences. You should discuss the tax implications of pledging securities as collateral with your tax advisor. All securities and accounts are subject to eligibility requirements. Please read all lines of credit documents carefully. The proceeds from an asset backed line of credit may not be used to purchase additional securities or pay down margin. Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depend on the specific facts of your own situation at the time your taxes are prepared. The strategies discussed in this report may be unsuitable for some clients depending on their specific objectives and financial position. Hypothetical examples do not represent actual performance results achieved and are for illustrative purposes only. Dodd-Frank regulations require that any swap marketing activities be conducted solely by Associated Persons (or APs ), which will limit the role that RMs, credit officers, investment bankers and other non-associated Persons can play in the swap marketing process. Non-APs are strictly prohibited from recommending or presenting specific swap or FX structures or transactions to clients. Only APs can engage in these activities. If you have a question as to whether or not you are an Associated Person, contact WFS compliance (g=dfcomplianceteam@wellsfargo.com) or International compliance (fxcompliance@wellsfargo.com). This is a solicitation for entering into derivatives transactions regulated by the Commodity Futures Trading Commission ( CFTC ) for the purposes of, and to the extent it is subject to, CFTC Regulations 1.71 and 23.605 promulgated pursuant to the U.S. Commodity Exchange Act ( CEA ), and is not a research report as defined in CFTC Regulations 1.71 and 23.605. This communication should not be construed as a recommendation or opinion with respect to any derivative or trading strategy involving a derivative for purposes of CFTC Regulations Part 23 or the CEA. This solicitation does not take into account the particular investment objectives, financial conditions, or needs of individual clients and is not intended to serve as a basis for entering into a derivatives transaction or to suggest, through opinion, recommendation, or otherwise, that the counterparty should enter into a particular derivative transaction or trading strategy involving a derivative. Parties should consult their own advisors for opinions on whether to enter into any derivative transaction or trading strategy involving a derivative. 2014 Wells Fargo Bank, N.A. All rights reserved. Member FDIC. NMLSR ID 399801 TPB01593 (201405006 05/14)