Understanding the complex world of interest rate derivatives can be a daunting task. These industry insights will shed light on how you can manage your interest rate risk. We’ve been hearing how interest rates are going to climb for the last three years. Esteemed panelists and prognosticators keep telling us rates have only one way to go, and that is up.
But we need to quantify exactly what that means. Are we talking about LIBOR or term rates? It’s an easy bet to say LIBOR is going higher given we are currently near 0%. The question is when, how high will LIBOR go, and what does that mean for term rates?
The LIBOR futures market thinks it knows where LIBOR will be in 3 months all the way out to 10 years. Given the LIBOR futures market trades around a trillion dollars a day you would think the market knows which way rates are heading. History tells us otherwise. The LIBOR futures market is a terrible predictor on the direction of short-term rates which in turn is the predictor for long-term interest rates.
Long-term interest rates are simply what the market expects short-term interest rates to average over that period of time. For example, 1M LIBOR is around 0.17% and the 10 year swap rate is 2.65%. The market is telling us 1M LIBOR is expected to average 2.65% over the next 10 years.
About a year ago, the market expected LIBOR to average 1.65% over 10 years. Over the past 5 years the 10 year swap has averaged 2.80%. Over the past 5 years, 1M LIBOR has averaged 0.35%. About 5 years ago borrowers had the opportunity to fix the 10 year swap rate at 2.50%. At the time, this was a 20 year low. Now consider if one had fixed the 10 year rate 5 years ago at historic lows. What happened over the next 5 years is LIBOR ended up averaging 0.35%.
What does all this mean for borrowers/investors? It’s simple, the market is always wrong. Historically, a borrower would have been better off with floating rate debt. Does that mean this will be true for the next 10 years? Borrowing at LIBOR 0.17% is very attractive versus paying 2.65% to lock-in LIBOR for 10 years, especially since the futures market isn’t expecting LIBOR to rise above 1.00% until the beginning of 2016 and 2.00% at the start of 2017.
Managing interest rate risk is extremely challenging and complex, especially under these unprecedented economic times. Interest rate derivatives allow borrowers to manage interest rate risk that meets their goals and objectives. For instance, interest rate caps and structured options could allow a borrower to float while still providing protection if LIBOR rises above a pre-determined level. Expected future fixed rate borrowings can also be hedged with options or forward starting swaps. One can even convert fixed rate debt to floating with the use of derivatives.