Managing Interest Rate Risks

Phil Kenkel

Bill Fitzwater Cooperative Chair

Oklahoma State University

One of the many risks facing the cooperative firm is interest rate risks.  We have enjoyed a period of historically low and stable interest rates which history suggest will someday come to an end.  The challenge is determining when rates will rise.  The two aspects of debt financing that create risk are the duration of the loan and whether the interest rate is fixed or variable.

The question of loan duration relates to a concept called asset-liability mismatch.  As an example consider a cooperative that borrows short term funds at 3% interest to finance a grain structure that is projected to have a 8% return on assets.  If short term interest rates spike to 10% in later years the grain bin will no longer be generating sufficient income to cover the interest cost.  To avoid asset-liability mismatch the general recommendation is to match the length of the loan term with the useful life of the asset.  Most cooperatives have a seasonal line of credit which is only used to fund short term assets and a fixed length term loan which finances a bundle of assets.  In most cases asset-liability mismatch is not a major issue.  If your cooperative is considering a major infrastructure investment with significant debt financing you might want to explore a separate term loan, linked to asset life rather than simply rolling the debt into your existing term loan structure.

The second, timelier, component of interest risk management is the mix of fixed versus variable interest rates.  Different managers pursue different strategies based on their risk aversion, outlook on interest rates, and their cooperatives risk capacity.  Some managers concentrate on variable rates (with lower interest rates) until they perceive that rates are increasing.  The challenge with this strategy, just like in marketing wheat, is in timing the market.  The goal of the fed’s quantitative easing was to flatten the yield curve (push down long term rates).  With fed chair Bernanke hinting at the beginning of the end of quantitative easing, a steeper yield curve could be on the way.

Rather than out guess the Federal Reserve or forecast interest rates, a better strategy might be to fix the rate on a portion of your long term liabilities.  In considering this strategy managers and boards should consider both their risk aversion and their cooperatives risk capacity.  Variable interest rates create one more risk bucket that the management team must keep an eye on.  The other consideration is how interest rate changes would impact the cooperative.  Tools such as my cooperative financial simulator can be used to analyze the impact of higher interest on cash flow, patronage and equity retirement budgets.

Economists are famous for projecting the past with increasing accuracy.  Ask me in a few years and I will be glad to tell you when you should have locked in rates!