The Flat Yield Curve is Frustrating Bankers

Loan Structuring - A guy holding his head in frustration

A flat yield curve has us scratching our heads – should we be originating fixed or floating rate loans?  If bankers believe that the current shape of the yield curve is a harbinger of an impending recession, then booking fixed rate loans may be a winning strategy.  However, if you believe, as we do, that there simply isn’t enough data as yet to point with a moderate degree of confidence to an economic recession in 2019 or 2020 then booking floating rate loans may be a better strategy.  We have developed a technique and loan structure to assist bankers who espouse the former scenario and are looking for a strategy to price relationship customers that works best when interest rates may be heading down temporarily in the next one or two years.  The strategy allows banks to withstand downward pressure on margin for one or two years if interest rates were to fall (as they might be expected to do during a recession), but still mitigates long-term interest rate risk, and the strategy creates an appealing liability profile for many borrowers with long-term financing needs.  

 

Current Environment

We may currently be in a period of greater inherent economic, policy and financial uncertainty.  The flat yield curve may be an expression of risks to the U.S. economy, the global economy, or a reflection of the possibility of risks of a policy mistake.  However, despite the flat yield curve the majority of pundits, economists and policymakers do not sound alarms on the current state of the US economy.

Last week current and former U.S. central bankers said the economy is still on track for growth this year and next year despite concerns in the financial markets.  John Williams (President of Federal Reserve Bank of NY),  James Bullard (President of the St. Louis Fed), Randal Quarles (Federal Reserve Vice Chairman for Supervision), and Janet Yellen (former Federal Reserve Chairperson) all downplayed fears of recession risks and expressed upbeat baseline economic expectations. 

But for bankers that believe that a yield curve inversion may indicate lower interest rates in the future are more likely than higher rates, we have developed a compelling loan structure called the Forward Floater.

How it Works

The idea behind a Forward Floater is to divide the life of a term loan into two different phases and in each phase structure a payment stream that is most appealing for the lender.  Many conservative borrowers still desire fixed rate certainty on term loans, and lenders want a fair yield on a loan without taking interest rate risk.  The Forward Floater achieves all of those objectives by dividing the loan into two phases as follows:

Phase 1 is a one or two year period during which the lender is earning a fixed rate yield.  If interest rates decline, the bank’s yield remains steady. 

Phase 2 is a five year to an 18-year period during which the lender is earning an adjustable yield.  During this phase, if interest rates fluctuate, the lender’s NIM is stabilized, and if interest rates increase substantially, net interest margin (NIM) will expand. 

During Phase 1 and Phase 2, the borrower pays the same fixed rate of interest, and the two phases are only apparent to the lender.  We use the ARC program to convert the adjustable rate during Phase 2 from floating to fixed for the borrower (without using a derivative for the bank or the borrower).  The graph below demonstrates the phases and borrower payment versus lender yield for current interest rates.

Forward Floaters - Graph of interest rates showing how borrers can receive a fixed rate during the first 2 years and the a floating rate after 

Why The Forward Floater Today

The above graph demonstrates the borrower is paying 5.00% fixed for the entire 10-year life of the loan, while the bank receives 5.00% fixed for two years followed by an adjustable rate that is determined by the then prevailing short-term interest rates.  The current forward curve shows that the future expected short-term rates are almost the same as current rates (thus the flat shape of the yield curve).  The Forward Floater makes sense today for the following reasons:

  1. Rates are low, and many borrowers want to lock in the cost of funding their business for longer periods.
  2. Because the yield curve is flat, the borrower does not pay a premium for longer-term fixed rates.
  3. The lender eliminates any risk associated with decreasing interest rates during Phase 1 of the loan.  This is appealing for bankers that have a negative view of the economy in the next one or two years.
  4. Again, because of the flat yield curve, the lender is expected to recognize the same adjustable yield for 5 to 18 years as the borrower pays from day one (in fact, last week lenders were accruing an adjustable yield above the rate paid by borrowers out to 10 years on the curve).  However, interest rate risk is eliminated during Phase 2 because the adjustable yield will move closely with the bank’s cost of funding.
  5. Lastly, the difference between converting the entire loan term from floating to fixed versus the last 5 to 18 years from floating to fixed only adds two to three basis points in additional cost for the borrower.   

 

Conclusion

A tough competitive environment coupled with a flat yield curve motivated us to come up with a novel solution.  The Forward Floater may be the right solution in circumstances where the community bank requires a fixed yield in the short term but interest rate protection over a longer period, and credit enhancement for the borrower.  In a commoditized lending world, the Forward Floater is a unique structure that may set your bank apart and distinguish your commercial lenders.