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Should agribusinesses fix their interest rates?

Should agribusinesses fix their interest rates?

February 25th, 2014

Recent low interest rates have encouraged some agribusiness owners to fix their rates, but that can be a mistake, says Hayden Dillon, Managing Principal, Waikato, for Crowe Horwath. Constantly changing market conditions mean it is crucial for interest-rate hedging to be treated as part of an ongoing strategy.

“Hedging is not a single event,” said Mr Dillon. “Very few businesses remain stagnant and the market never remains stagnant. Having an understanding of the impact of likely significant changes in your business is critical to being successful. And having a clear strategy around exactly what you’re trying to achieve is the first and most important step.”

Because there are a number of often complex financial instruments available, Mr Dillon recommended managing interest rate hedging through an independent advisor who specialised in the field, rather than a banker or accountant.

“The first thing we recommend is to develop a hedging strategy with an independent advisor who is not only an expert in financial instruments, but also understands agribusiness. Then we suggest working collaboratively with the bank’s rate specialist to implement and manage the business’s strategy. Ideally this would be part of your ongoing relationship focusing on other parts of your business success.”

Mr Dillon noted that since the Global Financial Crisis in 2008, floating rates have been at historic lows. But with the positive talk around New Zealand being a “Rock Star” economy, limited capacity within our economy to increase output, and an improving global outlook, many businesses were asking the question, “Should I fix, and if so, for how long?” he said.

Mr Dillon said that the New Zealand interest rate curve was already pricing in a rise of around 2% over the next two years in the Official Cash Rate (OCR) set by the Reserve Bank. The current Five Year Swap rate is around 4.6%, almost in line with forecasters’ expectations of an OCR peaking at 5.25% in the second half of 2017.

This was creating a steep rate curve. But New Zealand’s current OCR is at an historic low of 2.5%. Inflation has been benign, but data released in January showed that there was an unexpected jump of 0.1% over the last three months.

The current “high side” inflation scenarios are: a continuation of a broad economic expansion in the New Zealand economy, limited spare capacity in the economy to absorb that, house price appreciation continuing with little abatement, the Christchurch rebuild spilling over into inflation pressure, and a potential NZD/USD decline greater than that expected.

“Globally US momentum could build more quickly than expected, which could see US bonds increase on the back of a possible Federal Reserve Hike,” he said. “In addition, Australian growth concerns could prove to be short-lived and Australian bond yields could end up higher than forecast.”

Another potential inflationary outcome could result from unintended consequences of the Federal Reserve’s Quantitive Easing, in which an unimaginably large amount of money has been pumped into the US economy and corporate balance sheets, said Mr Dillon. “If that really starts to flow as confidence returns, the impact could be quicker than the markets expect, and too quick for the Federal Reserve to react,” he said.

Alternatively, there were a number of “low side” inflation scenarios, in which; domestic growth does not materialise affecting a fragile confidence, initial hikes in the OCR have an exponential bite in slowing the economy and negating the need for more (according to Reserve Bank data, 74% of mortgage borrowing is floating), and the New Zealand dollar remains elevated or even gets pushed up to new highs.

But Mr Dillon cautioned that hedging decision-making should not begin with consideration of low or high inflation/growth scenarios, but rather with an examination of the agribusiness’s motivation.

This generally falls into two categories: debt level gearing — i.e. how susceptible is the business to rate movements, in terms of the impact on profitability, and even survivability. The other is the agribusiness owner’s personal risk tolerance.

Having an understanding of the impact of changes on the business is essential. Stress testing can help the owner understand where the business is vulnerable, and help in making and implementing policies and decisions that are economical to the business.
Specialist advice is recommended, said Mr Dillon.

“As an example, Interest Rate SWAPS have received a lot of negativity, and rightly so in many cases, but in the current market, for the right client with the right strategy they can be an important hedging tool, so long as the features of the instrument are understood. Hence the need for specialist independent advice.”

The discussion with the specialist should be ongoing and in line with the amount of debt and potential leverage, said Mr Dillon, especially for large operators. He noted that 10 basis points of interest on $15 million in debt was $150,000, meaning that hedging required a considerable investment of time and expertise.

“The major agribusiness banks will have an interest rate specialist, who works solely in the interest rate market,” said Mr Dillon.

“Once you have a clear strategy, they are the right people for you and your advisor to be talking too. The relationship banker, while very knowledgeable on farming and credit risk, by virtue of their role is less likely to be able to provide as good a commentary on the current interest rate market. An independent advisor should also have a good understating of how your business appeals to the lender and therefore be able to provide guidance on what market rates you can expect.”

About Crowe Horwath
Crowe Horwath New Zealand is the largest provider of practical accounting, audit, tax and business advice to individuals and small and medium businesses from a comprehensive network of over 20 offices. Crowe Horwath is part of a global accounting network that delivers high quality audit, tax and advisory services in over 100 countries. We are the relationship that you can count on - large enough to offer a range of expertise and skills - and small enough to provide the personal touch.

ENDS

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