Roger J Kerr says borrowers need to use longer dated swaps to get the positive values to immunise year to year interest costs against adverse market movements

 By Roger J Kerr

Last Friday’s US employment number of only 74,000 new jobs (against forecasts of +195,000) looks like a rogue figure to me.

Adverse climatic conditions reduced jobs in the construction sector and Obamacare uncertainties reduced new hires in the health sector.

Watch out for major revisions upwards for prior months when next month’s figures are released.

The resultant pull back in the US 10-year Treasury Bond yield from 3.00% to 2.86% provides a window of opportunity for those local corporate borrowers who did not get fixed rate swaps entered last year.

The five year swap rate has re-coiled a touch to 4.65% from 4.75%. I would not expect term swap rates to move any lower as NZ and US economic performance continues at a decent clip and that eventually leads to rising inflation.

The US Federal Reserve is now on their steady and moderate course or removing stimulus and one month’s weak employment figures will not disrupt that charted direction.

The fulcrum of our swap yield curve from 90 days to 10 years is the three year area with US long term interest rates driving our interest rates from three to 10 years and NZ economic performance/monetary conditions determining the 90 day to three year part of the yield curve.

Current three-year swap rates at 4.17% have already priced-in substantial increases in 90 day rates over the next two years; however they have also been pulled up by the US interest rate market.

A borrower fixing for three years today at 4.17% would be a marginal hedge in my view, if the swap rate moves above 4.50%.

I would take floating rate risk instead of fixing.

Fixing in the five to seven year term still has some merit on the view that our longer dated swaps can still increase by another 0.50% to 0.75% over 2014 as US bond yields move up.

While fixed swap rates 4.75% to 5.00% may not be lower than average 90 day rates over the period, the longer-dated swaps will have positive value in 12 to 18 months time that can be applied across the whole debt portfolio to reduce current and future interest cost.

If a borrower never does longer dated swaps they will never have the opportunity to apply the positive value in those swaps to immunise year to year interest costs against adverse market movements.

Therefore, borrowers with increasing debt levels over coming years, or borrowers with a swag of historical swaps maturing over the next 18 months causing their portfolio fixed percentage to decrease should still be looking at entering new swaps, even if the forward starts rates are getting somewhat above 5.00%. 

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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com