In the wake of the 2008 economic meltdown, companies that had once enjoyed cheap, easy access to capital found themselves staring into the void left behind by a rapidly contracting lending market.
Memories are still fresh nearly five years on, and many organizations are proceeding cautiously. The challenge today, according to Brian Allard, partner, mergers and acquisitions at Ernst and Young, isn’t just on minimizing the cost of capital, but on ensuring long-term access to that capital.
“You never know if and when a 2009 is going to occur again,” he says. “That’s a lesson that sophisticated companies have learned. They won’t allow themselves to be in that position again.”
Canadian companies, however, are well situated today, compliments of low interest rates and a healthy domestic lending market.
“These are incredibly good times to borrow money,” says Laurence Booth, professor of finance at the Rotman School of Management. “Unlike the U.S. and U.K., [Canadian] banks are lending; the only restriction they face is in private mortgage lending where the government is afraid of a housing bubble.”
Many organizations are taking advantage by borrowing heavily and stockpiling cash. To them, the low cost of borrowing outweighs the risks of another unexpected contraction in the lending market.
On the flip side, companies looking for access to credit have less choice than they did in the pre-recession environment, as many lenders remain cautious, and there are fewer of them. “Today, there are still some good products out there, it’s just there aren’t as many,” Mr. Allard says. “That’s the biggest change we’ve seen; there’s less choice.”
These limitations were a concern of an automotive parts manufacturer, whose $30-million term loan was set to mature in one year. Financial executives wanted to protect the company against a potential hike in interest rates, as well as to ensure access to the capital they needed when the time came.
The company considered their conventional options. The first was to pay off the loan and arrange new financing, but this would have required a prepayment penalty on the existing loan. The second option was to pay the loan as scheduled, arrange new financing, then put the money down on their balance sheet, but this meant sitting on redundant cash while paying interest on it.
Unsatisfied with these choices, the company turned to the derivatives market, opting for an instrument known as a forward swap. Essentially, this allows a borrower to exchange floating rate payments on a future loan for fixed ones. Interest rate swaps in general provide much-needed flexibility in the current market, and allow organizations to ensure stable financing at a fixed rate for terms of up to 30 years.
“It makes particular sense these days because the yield curve is relatively flat,” Mr. Allard says. “There’s not a big penalty to lock in a forward rate of interest, as opposed to taking the money today.” For their part, the automotive parts manufacturer paid 4.6 per cent on their loan, or 0.4 per cent above the then-current rate.
Financial derivatives are sophisticated products, and it’s important to work with an experienced broker who has a thorough understanding of the options available. Financial executives also need to be prepared to solicit proposals from various parties and institutions to ensure they are getting a competitive offer.
Building positive relationships should be an ongoing process, not something a company does when it needs capital. This means meeting regularly with lenders, encouraging them to get to know your business, and building mutual trust.
“We tell clients it’s not always about getting the cheapest money,” Mr. Allard says. “Other things are important, like the long-term relationship that you are establishing with that bank or institution, and whether they are going to be flexible when times get tough.”
While derivatives present some important choices, many companies will find that the more conventional options suit their purposes.
Tim Sothern, a chartered accountant and partner with BDO Canada, has found that many are sticking with a variable rate. “Many companies are quite content with their variable interest rate debt instruments right now,” he says. “They’re confident that interest rates aren’t going to do anything drastic in the next few years.”
The swap question
Do interest rate swaps make sense for your company? Here are three questions to consider:
Are you sensitive to interest rate fluctuations? Some companies need to plan their cash flow very carefully and could be disrupted by a change in payments.
Are you willing to enter into a more complex arrangement? The derivatives market offers more flexibility, but it takes research and the right advice to ensure the best deal.
How important is piece of mind? Some people don’t mind a little risk, and others can’t sleep at night not knowing.