Assessing your system's CFC variable loan conversions.
As illustrated in Figure 1, the current CFC 7-Year SFR and long-term variable rates are at the lowest level experienced in a number of years. CFC's long-term variable rate of 4.750% (as of January 1, 1993) is the lowest variable rate that has been offered by CFC since the inception of CFC's variable rate program in April 1983. CFC's currently effective 7-Year SFR rate of 7.750% is only 0.500% above the lowest 7-Year SFR rate offered by CFC over the last 11 years.
Because of the large spread between CFC's 7-Year SFR and long-term variable interest rates, several members have converted to the variable rate on an interim or temporary basis, with the intention of converting back to a fixed rate in the future. Still other members have converted to the variable rate program on a semi-permanent basis, with little or no forethought as to converting back to a fixed rate. The following discussion provides a framework which can be used to assess the interest rate risk, the exposure to adverse financial consequences triggered by a change in the interest rates associated with the variable interest rate loans.
CFC will convert existing 7-Year SFR loans to either a fixed rate or a variable rate loan, for a fee, paid quarterly over the remaining quarters in the current cycle. If a loan is converted to the long-term variable rate, the loan can be converted back to the then-current fixed rate without incurring conversion fees in excess of those fees assessed upon the initial conversion.
Take for example a member converting its 7-Year SFR fixed rate Loan #9100, detailed in Table 1, under CFC's long-term variable rate program. The conversion fee, payable at the end of the first quarter, is the sum of 0.250% of the loan balance to be converted and an amount based upon the interest rate spread between the loan's existing fixed rate and the current 7-Year SFR. The conversion fees payable at the end of the remaining quarters in the current cycle are equal to the interest rate differential between the fixed rates. (The quarterly conversion fees are detailed in Appendix A.) The member would pay $31,228 at the end of the first quarter, and $17,349 at the end of the next seven quarters.
Table 1 CFC Loan Number 9100 Balance at Start of Current Cycle $5,700,000 Outstanding Balance at Start of Conversion $5,551,644 Quarters Used in Current Amortization 140 Number of Quarters Paid in Current Cycle 20 Number of Quarters Left in Current Cycle 8 Existing 7-year SFR Interest Rate 9.000% Quarterly Debt Service Payment $132,205 Current 7-year SFR Interest Rate 7.750% Current Variable Rate 4.750%
By converting to CFC's long-term variable rate, the member could reduce its borrowing costs in the short-term, since the variable interest rate is currently well below the 7-Year SFR rate. However, converting to the lower cost variable rate exposes the member to the prospect of increasing interest rates. As one measure of potential savings, we can assume that CFC's long-term variable interest rate does not change during the remaining quarters of the applicable cycles.
As detailed in Table 2, converting to the variable rate would generate net savings (after payment of the conversion fees) of $15,942 at the end of the first quarter, $29,822 at the end of the second through seventh quarters, and $125,410 at the end of the eight quarter. The cumulative net savings generated over the eight remaining quarters in the current cycle would total $320,282. On a discounted or present value basis, the net quarterly savings would total $286,436, based upon an 8.0% discount rate.
However, the long-term variable rate will change, and it is likely to increase over the next several years. In order to evaluate the relative risk of the long-term variable rate increasing, we can perform a break-even analysis. This analysis indicates that if the long-term variable interest rates average less than 7.686% over the remaining 8 quarters, the conversion of Note #9100 to the variable rate will either break-even or generate some net savings to the member.
Interest Rate Risk
The member's decision to convert to the long-term variable interest rate or to remain with the variable-rate program, will ultimately depend upon the corresponding interest rate risks the member is willing to assume in order to achieve the savings associated with the lower variable interest rate option. The interest rate risk is simply the member's exposure to adverse financial consequences triggered by a change in interest rates. Although each member with a variable rate loan(s) is faced with the same prospect of the variable rate increasing over time, the corresponding interest rate risks assumed by the members are not the same.
Table 2 Quarterly Accumulated Variable Savings Savings QRT 7-Year SFR Rate (Cost) (Cost) 0 $5,551,644 $5,551,644 $ 0 $ 0 1 (134,205) (118,263) 15,942 15,942 2 (134,205) (104,384) 29,822 45,764 3 (134,205) (104,384) 29,822 75,586 4 (134,205) (104,384) 29,822 105,407 5 (134,205) (104,384) 29,822 135,229 6 (134,205) (104,384) 29,822 165,050 7 (134,205) (104,384) 29,822 194,872 8 (5,605,377) (5,479,967) 125,410 320,282 Present Value @ 8.00% $286,436
The interest rate risk assumed by the member will fluctuate with the projection of future interest rates over time because the member's interest rate risk is a function of a number factors particular to that member's situation. These factors include the following:
* Equity as a percentage of capital structure;
* REA/CFC related mix of long-term debt;
* Variable/Fixed Rate related mix of loans;
* Remaining terms of REA/CFC fixed-rate loans;
* Interest rates on REA/CFC loans;
* Amortization of loan principal;
* Whether or not the member's rates are regulated by a state utility commission; and
* Existing level of Net Margins.
Since no two members are exactly alike with regard to the factors listed above, each member with a variable rate loan(s) will be faced with a different level of interest rate risks.
Risk Assessment Framework
In order to assess the relative interest rate risks faced by a member considering conversion of its CFC loans under the long-term variable rate or fixed rate programs, the member needs to be able to relate the potential changes in the debt service payments to the corresponding changes in the member's financial position. Financial ratios such as the Times Interest Earned (TIER), the Debt Service Coverage (DSC), and the Return on Equity (ROE) provide simple, yet informative, insights into the member's financial position. (The financial ratios are defined in Appendix B.) By comparing the member's resulting ratios under various potential actions to the member's current ratios, we can assess the relative interest rate risk faced by the member.
Once again, we can look at a member converting its 7-Year SFR fixed rate Loan #9100, previously detailed in Table 1, under CFC's long-term variable rate program. Table 3 summarizes the various factors associated with the XYZ Rural Electric Cooperative which will affect the interest rate risk faced by XYZ. This table also illustrates the calculations of the financial ratios. Although the Depreciation and Amortization Expense and Net Operating Margins figures are held constant, the remaining figures are calculated accordingly as noted. As detailed on lines 15-17. XYZ's Net TIER, DSC and ROE, prior to conversion, were 2.00, 2.16 and 8.00%, respectively.
TABULAR DATA OMITTED
With this framework, we can now assess XYZ's relative interest rate risk associated with the conversion under the variable rate program, by changing our variable interest projections. As summarized in Table 4, XYZ's Net TIER would jump to 2.28, if CFC's variable interest rate remains at 4.75% throughout the year. If we assume that the variable interest rate rises at a rate of 25 basis points per quarter, or averages 5.375% during the year, XYZ's Net TIER would be 2.21. As long as the variable interest rate averages less 7.25%, XYZ's Net TIER will exceed 2.00. It is important to note that XYZ's conversion fee payments to CFC are reflected in the financial ratios for 1993.
It is also important to assess the financial ratios after 1994 when there are no longer conversion fees. The Net TIER, DSC and ROE summarized in Table 4, are illustrated graphically in Figures 2, 3, and 4, respectively.
TABULAR DATA OMITTED
The financial ratios calculated in the example above were based upon the assumption that the member's existing rates were held constant. However, in practice the members can adjust their rates to reflect changes, either increases or decreases, in their interest expenses, through their periodic rate reviews.
Not surprisingly, the interest rate risk assumed by a member that is regulated is greater than the risk assumed by a non-regulated member. Since the regulated member's rates are subject to review by the state utility commission, the regulated member cannot immediately adjust its rates to reflect changes, either increases or decreases, in interest expenses. The regulatory lag, the delay between the point in time the need for a rate change is identified and when the adjusted rates are put into effect, exposes the member to greater interest rate risk.
With the historically low level of interest rates, and the large spread between CFC's 7-Year SFR and long-term variable interest rates, the member surely can reduce its borrowing costs in the short-term by converting to CFC's long-term variable rate. However, converting to the lower cost variable rate exposes the member to the prospect of increasing interest rates and the corresponding interest rate risk.
The member's decision to convert to the long-term variable interest rate or to remain with the variable-rate program will ultimately depend upon the corresponding interest rate risks the member is willing to assume in order to achieve the savings associated with the lower variable interest rate option. Although each member with a variable rate loan(s) is faced with the same prospect of the variable rate increasing over time, but corresponding interest rate risks assumed by the members are not the same.
Since there is no certainty as to future interest rates, only the member, its board and management, can determine the level of interest rate risk that the member is willing to assume.
TABULAR DATA OMITTED
* Net Times Interest Earned or Net TIER is equal to the "Patronage Capital or Margins" (line 27, Page 1 of 7, of the REA Form 7), plus "Interest on Long Term Debt" (line 15), divided by "Interest on Long Term Debt" (line 15).
* Debt Service Coverage or DSC is equal to the sum of "Patronage Capital or Margins" (line 27, Page 1 of 7, of the REA Form 7), "Interest on Long Term Debt" (line 15), and "Depreciation and Amortization Expense" (line 12), divided by "Debt Service Payments" (which includes all long-term interest and principal payments on REA, CFC or other loans).
* Return on Equity or ROE is equal to the "Patronage Capital or Margins" (line 27, Page 1 of 7, of the REA Form 7), divided by "Total Margins and Equities" (line 31, Page 2 of 7, of the REA Form 7).
Raymond J. Kilway is a consultant with C. H. Guernsey & Company located in Oklahoma City, Oklahoma. Guernsey is a diversified consulting firm which offers comprehensive engineering, architectural, economic, and financial services to public utilities, government agencies, and industrial clients throughout the country. Since joining Guernsey in 1981, Mr. Kilway has been involved in numerous projects relating to regulatory economics including cost of capital/rate of return analyses, revenue requirements, rate design, cost allocations, economic/financial modeling, forecasting and cost/benefit analysis.
Mr. Kilway received a bachelor of science degree in civil engineering from the University of Notre Dame in 1978 and a master of business administration degree with an energy concentrate from the University of Oklahoma in 1986.
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|Title Annotation:||includes appendices; National Rural Utilities Cooperative Finance Corporation|
|Author:||Kilway, Raymond J.|
|Date:||Dec 22, 1992|
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