By Mark Boada, Senior Editor
With short-term interest rates rising, fleets have a critical decision to make: whether to exercise the one-time option of converting their floating-rate leases to a fixed rate.
Floating rate leases are the smart choice when interest rates are falling, as they did during the Great Recession. The one-month London Interbank Offered rate, or LIBOR — the rate that many leasing companies use to set their floating rate interest charges — dropped precipitously during the Great Recession, plunging from more than 5.00% in 2007 to less than one of half of one percent by April 2009.
After that, in the face of continued global economic weakness, the rate drifted even lower, bottoming out in March 2014 at 0.15%, the lowest level in its 28-year history. Even with the addition of leasing companies’ typical quarter-point spread, the rate prompted comments that loans were like getting “free money.”
That all started to change, however, toward the end 2015 when, with a spurt, it started to climb. It rose to 0.43% by December, and hovered at around that level until the fall of 2016, when it began to climb steeply on a trajectory that has yet to flatten out. As of this writing (June 30) one-month LIBOR stood at 1.22%, more than an eight-fold increase since its historic low.
The reason for this upside reversal? It’s all about what the U.S Federal Reserve Bank does with the so-called “Federal funds rate,” the rate that banks lend to each other for overnight loans to meet their daily reserve requirements. LIBOR rates closely track the Fed’s changes, and the Fed had been lowering the rate steadily from June 2006, the eve of the financial panic that triggered the Great Recession, until December 14, 2015, when it raised the rate by one-quarter of percentage point, from 0.25% to 0.50%, when LIBOR started its ascension.
Since then, the Fed has bumped the rate up by the same amount three more times: in December 2016, again in March of this year and one more on June 14, to 1.25%. The Fed’s actions have been based on its concern over the possibility that declining unemployment rates, tighter labor markets and increased consumer spending could push up the U.S. rate of inflation.
Indeed, some Fed watchers believe that the central bank will decide on another rate hike before the end of the year, and several more both next year and in 2019. In their eyes, this would bring the Fed Funds and one-month LIBOR rates to around 3%, well more than double where they are now, and directly impact fleets with floating rate leases.
All of that may appear to be a strong case for flipping those leases to a fixed rate, right? Well, maybe. When you convert, leasing companies peg your fixed rate to the yield on debt securities with a maturity matching the remaining term on your lease and, typically, it’s higher than the one-month LIBOR rate.
For example, as of June 30, the yield on two-year Treasuries was 1.38% and on three-year notes it was 1.55%, compared to the one-month LIBOR rate of 1.22%. So, converting would entail an immediately higher monthly bill than you’re paying now. But what you would be doing is protecting yourself against any further increases in LIBOR that go above your newly fixed rate – IF, in fact, that happens. So what should you do?
First, fleets need to determine what rate they’re currently paying on their floating-rate leases, and then find out what fixed rates their leasing companies are offering. Then, fleet managers need to consult with their own business’s finance department to figure out a game plan that compares the higher interest charges that come with a new fixed rate to the chances that LIBOR-based leases might cost even more in the near future, and by how much. The upside to a conversion is the avoidance of a possible stream of higher expenses, potentially to the point where short-term, floating rates are higher than fixed rates. The downside is an increase in interest expenses for the remaining life of the lease.
As if it bears mentioning, no one – not even economists – knows the future for certain. To avoid being solely responsible for a decision on interest rates, fleet managers need the cooperation and support of financial professionals. Now is the time to seek them out.
