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Have you hedged your interest rate risk?

John Blanchfield for Progressive Dairy Published on 31 December 2019

Like milk prices, no one can accurately predict the direction of interest rates in the future. That being said, I firmly believe farm loan interest rates will rise (and possibly sooner rather than later), and producers should have a strategy to hedge interest rate risk.

Here is what we do know today: Interest rates for almost all types of borrowing are at near-historic lows. Low interest rates have kept our economy humming along quite nicely since the financial crisis of 2008-09. The Federal Reserve, believed to have great power over the future direction of rates, has generally kept rates low in order to defend our economy against a possible recession. The Federal Reserve is reaching the point where there is only one direction in the future: up.

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Farmers can hedge interest rates in ways similar to how they hedge milk price risk and input price risks. Interest rates are just another input cost; they are associated with the cost of a farm’s leverage and how that leverage is structured. The best news about hedging interest rates is: You don’t need to attend a special class on rate hedging. Your interest rate exposure can be managed by you and your banker at the institution where you borrow money. The process isn’t easy, but with a few actions on your part, you can make some very positive steps that will help insulate your business from future rate increases.

First, just because interest rates are low, it does not mean money is on sale. Do not load up on debt. In fact, just the opposite is true. Use low interest rates to aggressively reduce debt. Think about it this way: Low rates mean every payment you make on a variable-rate loan results in more of the principal being paid off. This is a good thing. I have encountered many operators who don’t want to pay off debt when rates are low because they fear they might not be able to borrow at the same rate in the future. This is the wrong way to think. Debt is debt. As a farm operator, your goal should be to retire debt. As long as you have debt, your operation is somewhat at risk. Reducing debt now is the most effective move you can make to hedge your interest rate exposure. Less debt equals less interest rate risk.

Second, understand that there is a close relationship between low interest rates and the value of farm assets. Low interest rates enable people to buy stuff they would not be able to buy if rates were higher. As a result, low rates get “bid into” asset prices. Anyone who has observed farmland values over the past 15 years can see that low rates have been very influential in the run-up of farmland prices. Why is knowing this important? If you are contemplating selling some or all of your farm assets, you want to do so during a period of low rates because when rates go up, farm assets, like your land, will tend to decline in value. So while it is impossible to time asset sales, you should keep in mind that interest rates have an impact on the price you are likely to receive should you decide to sell.

Third, structure your debt to take advantage of low rates. Most farmers have three types of debt: real estate, intermediate term and working capital/operating debt. One of the most effective hedges against higher rates you can take with your farm’s existing debt is to seek fixed-rate financing. But most lenders only offer fixed-rate financing on loans secured with real estate. And like most farmers, you hate the idea of having your farm real estate encumbered by debt. Your farm real estate is your savings account. If you want to lock in low fixed-rate financing for some or all of your operation, you will need to bring your real estate to the table. In over 40 years of looking at farm financial statements, I can tell you that many producers often overload their short and intermediate debt financing while not bringing their real estate to the table to properly structure debt. Restructuring your debt using your farm real estate is a big step. Make sure you have thought through your future plans and have taken the necessary steps to keep your operation working efficiently so you won’t need to restructure again for some time (or ever).

If you want to bring interest rate stability to your farm finances and take advantage of these historically low rates, talk to your banker about fixed-rate financing. Keep in mind the costs related to restructuring debt using real estate as collateral can be high, so you need to make sure that your plan is reasonable, achievable and effective. Your banker will want this as well because no banker will approve additional credit if all it does is chew up your equity.  end mark

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John Blanchfield directed agricultural banking policy at the American Bankers Association in Washington, D.C., for 25 years. Today, he owns Agricultural Banking Advisory Services, an independent consultancy that works for banks that lend to farmers and ranchers. He makes presentations about borrowing money to farmer and rancher audiences.

John Blanchfield
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