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In its response to the financial crisis, in 2009 the Bank of England (BoE) cut interest rates to an all-time low and embarked on an unprecedented programme of monetary stimulus known as quantitative easing (QE). The result of this was to reduce the cost of fixed rate borrowing, also to an all-time low. In this period of a low and stable BoE bank rate, interest rate risk is sometimes viewed as a lesser concern. This low BoE bank rate, however, has masked a period of substantial volatility in fixed borrowing costs (as shown in chart A), and with this period of central bank intervention likely to be coming to a close, borrowers should be aware of how quickly the interest rate market can react to economic indications.
Chart A: BoE bank rate and five-year fixed borrowing rates
Source: produced by Lloyds Bank using Bloomberg data. As at 03/12/2014
Chart A shows the rates available on new five-year fixed rate loans since 2009 and the BoE bank rate, with a particular focus on the past two years. The fixed borrowing rate represents the underlying interest cost and does not include the credit spread that is added to either a base rate or fixed rate loan, to determine the total rate of interest payable.
The chart shows that whilst the BoE bank rate has remained unchanged since early 2009, the cost of fixed rate borrowing has changed considerably in response to economic events. Fixed borrowing rates fell in 2009/10 in response to the financial crisis and the introduction of QE by both the Bank of England and the US Federal Reserve. These rates then increased quite substantially during a brief period of optimism in late 2010/early 2011, only to fall again as the scale of government debt in southern European countries threatened another global recession and potentially the break-up of the Euro.
2013 saw a reversal of this trend as optimism returned to the markets, following improved economic growth in the US and UK. As a result of this optimism, the US Federal Reserve announced that it would start to reduce or “taper” its QE programme with a view to eventually stopping the program all together, which coincided with a large increase in fixed borrowing rates. This optimism continued through most of 2014 but with economic growth starting to stall, particularly in emerging economies, worries resurfaced again in Q4 following the IMF downgrading its global growth forecasts.
In summary, the historic data tends to show that fixed borrowing rates can be volatile and could react very quickly to economic events. Any institution considering fixed rate borrowing should be aware that the market is likely to have already incorporated any anticipated future bank rate increases into fixed borrowing rates, by the time the Bank of England announces any such increase.
The prospects for 2015
It is unclear what the future path of interest rates will be. With growth in the UK potentially beginning to soften and inflation remaining below the Bank of England’s target range, Lloyds Bank feels that it might be difficult for governor Carney to argue for a rate rise early in the new year. Lloyds’ central forecast is for the first increase in the bank rate to occur in August 2015. By this time we should hopefully see stabilising conditions in the Eurozone and solidifying growth in the UK providing the backdrop to potential increases in interest rates. This outlook is highly uncertain, however, with potential risks in both directions. Building expectations of interest rate increases in the US could bring this date forward while, on the other hand, GBP forward markets currently do not expect the first increase to occur until December 2015.
Again this serves to highlight the uncertain and volatile environment behind the outwardly stable bank rate and underlines the importance for borrowers to consider what impact this might have on them.
Educational context
Any upward move in interest rates feeds directly into higher costs for capital projects that rely on lending. Consider a school that takes out a £10m 15-year repayment loan on 1 January 2014 to fund the construction of a new sports facility. The interest on this loan is currently linked to BoE bank rate, but the school is interested in converting to a fixed rate to gain greater cost certainty. The school is concerned about committing to a fixed rate and is waiting for greater economic certainty before making a final decision.
Chart B: Lifetime interest costs (excluding the credit spread)
Source: produced by Lloyds Bank on 03/12/2014. Lifetime interest cost calculated as cost of paying bank rate on the outstanding loan balance up until fixing and then prevailing fixed rate on the outstanding balance for the remaining term of the loan
Chart B shows what the lifetime interest costs of this loan would have been (excluding any fixed credit spread) had the school fixed the interest rate on any given day since 1 January 2014.
The chart shows that these costs have declined significantly, but the focus here is not the direction of the change but rather the magnitude of that change. Using the above example, there was a potential lifetime interest cost saving of £765,000, or £54,000 on average per annum, had the school fixed their borrowing on 1 December instead of 1 January. This is a saving of nearly 33 per cent on total interest costs (excluding credit spread) and could represent a valuable boost to the finances of any institution.
Of course, the school could remain floating and these costs could potentially reduce further in the future. Alternatively they could increase in the future and perhaps even result in costs that are higher than the original interest costs.
The key point is that this change occurred over a period where there was no movement in the bank rate.
By waiting to fix, schools could save money in the short term by continuing to pay the BoE bank rate on their loan, but may face higher costs over the long term if rates rise. Fixed rate markets react quickly to economic events and can price in predicted future bank rate increases long in advance of them actually occurring.
Schools should consider the impact of higher interest rates on any proposed borrowings and fixed rates is an option that could be explored with your lender. While fixed rates could provide greater cost certainty, borrowers should also be aware of certain risks in fixing interest rates, which includes potential penalties for making early repayments and, should rates fall once a loan has been fixed, the borrower may be liable to significant break costs on repaying the loan.
Ian Buss is Head of Education, Lloyds Bank Key Markets
E: ian.buss@lloydsbanking.com
