6 Main Types of Interest Rates
Focusing on the three sectors with the highest debt exposure, the projected increase in the policy rate is estimated to lower interest coverage ratios by from roughly 2. The energy sector has experienced negative interest coverage ratios in recent years, and the change in this ratio as a result of the projected rate hikes has negligible implications relative to those associated to low energy prices and weak earnings.
In summary, significant vulnerabilities to higher rates appear to be restricted to the real estate sector, mostly because of the large fraction of floating-rate debt in that sector. These estimates rely on three important assumptions and come with a caveat. First, the total debt and earnings levels and the proportions of bonds to loans and fixed- to floating-rate debt are not affected by the assumed change in the path of the federal funds rate. Second, the outstanding fixed-rate debt maturing over the next three years is rolled over at expected interest rates prevailing each year.
Third, increases in the federal funds rate occur in the middle of each year. The limitations of these assumptions are briefly discussed at the end of this note.
Interest Rate Floor Definition
Finally, as a caveat, the analysis cannot rule out that some individual firms may experience difficulties in the face of increasing rates. The analysis uses regulatory and public data on corporate loans and bonds to break down the portion of outstanding corporate debt with variable and fixed rates. This breakdown is used in combination with the maturity structure of this debt to estimate the change in interest expenses implied by the June SEP projected path for the federal funds rate through An increase in the federal funds rate is thus likely to affect the interest expenses for a large fraction of corporate loans.
Two factors may weaken the response of interest expenses of floating-rate loans to changes in the federal funds rate: interest rate floors or ceilings and infrequent rate resetting. While most term loans and lines of credit do not have ceilings, the majority of term loans with floating rates, and a nontrivial fraction of lines of credit, have floors.
Rates on term loans and lines of credit typically reset to the level of their reference rate on a quarterly basis. This factor might limit the short-term effect of the SEP-projected rate hikes, as it could take a few months before the rate hike translates into increases in the floating interest rates of loans. However, quarterly resetting does not weaken the longer-term reaction of interest expenses to further interest rate increases.
Interest Rate Ceiling Definition
Fixed-rate loans might not be immune to interest rate increases either. Most of these bonds pay fixed coupons, as bonds with floating rates represent only 2. Bonds that mature in and account for about 9 percent and 5 percent of the total amount outstanding of investment- and speculative-grade bonds, respectively table 3. Note: Amounts are in USD billions.
Figures in parenthesis are percentages of total amount outstanding by credit category. Return to text. This section provides estimates of the increase in interest expenses for nonfinancial corporations under the federal funds rate path implied by the June SEP, which projects a tightening of 24 bp in the policy rate in , 70 bp in , and 90 bp in It is assumed that all floating-rate loans reset immediately to their new reference rate and that they are rolled over once they mature.
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Similarly, fixed-rate bonds and loans are assumed to be rolled over immediately after maturity with a new time to maturity equal to the weighted average maturity of bonds and loans in the sample, respectively, and a coupon rate equal to current market yields plus the projected cumulative federal funds rate hike at the time of rollover. Figure 1 plots the evolution from to of the interest coverage ratio, defined as the ratio of EBIT to interest expenses. An increase in the federal funds rate, as implied by the path forecast in the June SEP, is estimated to decrease the coverage ratio to 4.
Accessible version. The modest vulnerability found for the aggregate nonfinancial corporate sector can mask more significant risks in some industries.
In particular, sectors with high leverage and high exposure to interest rate changes may be more sensitive to an increase in interest rates. Ippolito, Ozdagli, and Perez-Orive show that monetary-policy-induced changes to interest rates significantly affect the balance sheet liquidity, valuation, and investment of financially constrained firms that use floating-rate debt relative to similarly indebted firms with fixed-rate debt.
Figure 2 shows the levels of the interest rate coverage ratios in using information from the Bureau of Economic Analysis. The low interest coverage ratios of the energy mining , utilities, and real estate sectors make them of particular interest. Table 5 displays the total volume of outstanding bonds and loans as of March in each of these three sectors. While the utilities and energy sectors rely primarily on bond financing 88 percent and 90 percent of their total debt consists of bonds, respectively , about half of the outstanding debt of the real estate sector consists of loans.
The loans overwhelmingly feature floating interest rates in the three sectors. An increase in the federal funds rate is thus likely to affect the interest rate expenses for a non-negligible fraction of corporate loans. Figures in parenthesis are percentages of total amount outstanding in the sector. Table 6 displays the maturity structure of the outstanding bonds and fixed-rate loans for the three sectors by year until It shows that fixed-rate loans have significantly shorter maturities than bonds across sectors.
We calculate the estimated increase in interest expenses for the three sectors following the same procedure as for the aggregate debt. Note: Amounts are annual, in USD millions. The values are the total of interest expenses of loans and bonds. To compare the magnitude of these additional interest expenses, figure 3 plots the historical and the forecast path of the interest rate coverage ratios for the three sectors. The results suggest the three sectors are not equally vulnerable to an increase in interest rates.
Potential vulnerabilities appear to be isolated to real estate firms, as a larger portion of their debt is floating rate. Even so, the deterioration in the coverage ratio for this sector is projected to drop just below the mean value of its historical distribution since The energy sector currently has a negative EBIT, which makes the interpretation of the interest rate coverage ratio less straightforward. However, the change in the interest rate coverage ratio from the projected rate hikes is modest, particularly relative to the larger effect caused by weak and volatile earnings in the sector.
Note: Interest rate coverage ratio is measured as the ratio of the earnings before interest and taxes EBIT to the interest expense of each industry. Final Comments The analysis above shows that the current expected path of the federal funds rate implies a modest deterioration in the nonfinancial corporate interest coverage ratio both at aggregate and sectoral levels.
The analysis suggests limited risks in the ability of the U. There are several caveats in the analysis that deserve further mention. First, it is assumed that the amount of debt outstanding and earnings remain at current levels during the forecast horizon independently of the level of the federal funds rate. This assumption does not seem ill-founded for the amount of debt outstanding in light of the well-documented evidence of sticky corporate leverage.
However, earnings may be sensitive to changes in interest rates through demand and supply channels. Distinguish between the primary market and the secondary market for securities. As interest rates in the market change over time, the market price of bonds rises and falls. The change in the value of bonds due to changes in interest rates is a risk incurred by bond investors.
What is this risk called? A call provision on a bond allows the issuer to redeem the bond at will. Investors do not like call provisions and so require higher interest on callable bonds. Why do issuers continue to issue callable bonds anyway? What is a sinking fund? Do investors like bonds that contain this feature? What is the minimum price of the bond? Share this link with a friend: Copied!
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