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By: Erik Kelly, President
Borrowers of long-term debt are always faced with this question: should we borrow on a fixed rate or a variable rate basis? This question arises irrespective of whether the borrowing will occur on a taxable or tax-exempt basis, or whether the borrower is a governmental, non-profit or corporate entity. It is a question that, at times, seems simple to answer. Certainly, there are instances when budget certainty is strongly preferred if not required, leading to the quick decision to issue fixed rate debt. Further, in current market conditions where both short and long-term interest rates are extraordinarily low – near all-time lows, in fact – it can be difficult to pass up the low, long-term cost certainty of fixed-rate borrowing. Yet for some borrowers and in many instances the decision is not so clear cut. Now, during a period of all-time low rates, the Federal Reserve has given us another consideration to make in answering the fixed versus variable rate question.
Last week Federal Reserve Chairman Jerome Powell revealed the Fed has adopted an average, rather than a specific, inflation target. While the inflation target remains at the same 2% threshold, it is based on the average inflation rate over time rather than, as has been understood historically, a 2% inflation cap. Here’s a snippet of Chairman Powell’s remarks from last week (the full speech can be found here):
“In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting.” - Federal Reserve Chairman Jerome Powell
For starters, this statement identifies not only the change in policy by measuring inflation over time (i.e. averaging), but it also identifies the flexibility the Fed is seeking to manage the inflation target. In other words, if the Fed isn’t going to be specific on the methodology for measuring the inflation rate, then it seems it will be difficult for the Fed to get their fiscal policy wrong (or even right!).
More importantly for borrowers, one could surmise the Fed’s policy change is a simple tweak around the edges. What does it matter that the Fed is considering an average 2% inflation rate versus a static 2% inflation ceiling? I would impress upon you that the implications could be dramatic. Already we know that the Fed is willing to be accommodative with their monetary policy in the midst of an economic downturn as a result of the COVID-19 pandemic. In fact, the Fed has identified an expectation to keep the Fed Funds benchmark rate near 0% for an extended period of time, likely through 2022. This expectation was set even before the recent inflation target policy change. Now, given the U.S. annualized inflation rate has been below the 2% target for five of the last seven years (and below 1% since April 2020), an averaging of inflation over time suggests the Fed can be accommodative for an even longer period of time going forward. As such, it is more likely now that a near 0% Fed Funds rate could exist beyond 2022. While the inflation rate may exceed 2% during an extended time period, the “average” inflation rate over time could easily be calculated to remain at or below the 2% target. Thus, it appears the Fed will be in no rush to increase short-term rates.
Fixed or variable rate? It is, indeed, a worthy debate. And while future rate expectations are only one aspect of the discussion, perhaps in consideration of the Fed’s recent inflation policy change the pendulum has swung just a little in the direction of variable. Our team looks forward to engaging you further in this discussion.
About the Author:
Erik Kelly
President | ekelly@blueroseadvisors.com
Erik Kelly serves as President of Blue Rose, providing leadership, coordination, and oversight of the firm’s advisory services since 2011. He also serves as the lead advisor to many of the firm’s clients, including advising higher education, non-profit, and other borrowing entities on the planning for and execution of all types of debt and debt-related derivative transactions. In managing the firm’s various advisory service areas, Mr. Kelly oversees both compliance with the changing regulatory environment and the delivery of professional advice to the firm’s clients.
Education
Mr. Kelly holds a bachelor’s degree in economics from Amherst College and a master’s degree in theological studies from Bethel University. Mr. Kelly passed the MSRB Series 50 Examination to become a qualified municipal advisor representative and the MSRB Series 54 Examination to become a qualified municipal advisor principal.
Comparable Issues Commentary
Shown below are the results of two negotiated taxable higher education issues that sold in the month of August. Rutgers, the State University of New Jersey (“Rutgers”) and Baylor University (“Baylor”) priced taxable bond issues on August 4th and August 6th, respectively. Both transactions were solely issued for refunding purposes, with Rutgers advance refunding its NJEDA Series 2013 Bonds and Baylor refinancing its Series 2011, 2012, and 2017 bonds, as well as funding a swap termination payment and the repayment of outstanding commercial paper notes. The two taxable bond issues were extremely similar in size, with Rutgers issuing $220.9M for its 2020 Series S Bonds while Baylor’s Series 2020B issue was only slightly smaller at $217.435M. Baylor issued a concurrent tax-exempt issue (Series 2020A) as well, which also served to refund a portion of its Series 2017 bonds. Rutgers’ bonds were rated “Aa3/A+” (Moody’s/S&P), while Baylor’s bonds were rated “A+/A+” (S&P/Fitch).
Both universities priced at a favorable time in the market, with US Treasury rates once again at or approaching all-time lows at the beginning of August, before increasing again later during the month. While taxable credit spreads remained meaningfully wider than pre-COVID-19 levels, both institutions were able to lock in attractive costs of capital, with the final maturities of each taxable issue (falling in 2046 for Rutgers and 2050 for Baylor) pricing at interest rates below 3%. The two bond issues utilized relatively similar maturity structures (ranging from 2027-2046 for Rutgers and 2026-2050 for Baylor). However, the two universities opted for different call features, with Rutgers pricing its taxable issue with a make-whole call while Baylor opted for a 10-year par call provision (although Baylor’s 2020B bonds also included a make-whole call prior to the par call date).
Interest Rates
Blue Rose Announcements
Blue Rose’s Justin Krieg promoted to Senior Vice President
Justin Krieg provides financial and economic consulting services to the firm’s clients. Within the firm’s P3 advisory practice, Dr. Krieg utilizes his knowledge and experience to assist clients in understanding the P3 approach to procurement, determining the appropriateness of the range of delivery methods, and ensuring that the long-term P3 partnerships rest on a secure financial and economic foundation. In his work for clients, Dr. Krieg specializes in the evaluation of the economics and assumptions that underpin dynamic cash flow project models, and closely studies how certain models will perform economically across the range of inputs and stress-tests. His work also helps to inform risk transfer and mitigation concepts with private partners.
Blue Rose’s Brandon Lippold, promoted to Assistant Vice President
Mr. Lippold joined Blue Rose as a Quantitative Analyst, providing modeling, analytics, market data, and research in support of the delivery of capital planning, debt and derivatives advisory, and reinvestment services to our clients in 2018. He then took on the role of Associate, where he utilized his experience as a Quantitative Analyst in a more client-facing role, while still performing much of the analysis utilized in this capacity in 2019. In his new role, he will be tasked with growing client management responsibilities, in particular ensuring that our clients’ transactions run smoothly through closing.
Blue Rose’s Georgina Walleshauser, promoted to Associate
Ms. Walleshauser joined Blue Rose in 2017. As an Analyst, she was responsible for providing analytical, research, and transactional support to senior managers serving higher education, non-profit, and government clients with debt advisory, derivatives advisory, and reinvestment services. She also prepared debt capacity modeling, credit analysis, and market analysis to support the delivery of comprehensive, strategic, and resourceful capital planning tools to our clients. In her new role of Associate, she will utilize her experience as a Quantitative Analyst in a more client-facing role, while still performing much of the analysis utilized in this capacity.