External Capital Formation in a Higher Rate Environment

Current Funding Environment

The Fed and friends are in beautiful Jackson Hole, WY, from August 24 - 26. We’ll see what comes from that session but in the meantime, long-term funding rates have been moving up. Friday’s Wall Street Journal noted that 30-year mortgage rates have reached 7.23%—the highest since 2001–and that the spread to Treasuries has been widening, in part due to illiquidity on the secondary market. That said, the Chicago Fed’s National Financial Conditions Index is back down around negative 0.40, which is where it was in early March 2022 (negative values for this index suggest a relatively accommodative financing environment). It remains a strange and challenging moment.

SIFMA reset this week at 4.47%, which is approximately 84.3% of daily SOFR* and represents a +147 basis point adjustment versus the August 9, 2023, reset.

*Daily SOFR quoted as of 8/24/2023 – 5.30%

Balancing the Tingle and the Chill

Along with my wife getting her driver’s license, the other fun thing that happened on February 2, 1975, was Loretta Lynn releasing “When the Tingle Becomes a Chill,” which could be the theme song for all those lamenting our current restrictive Fed:

Sometimes at night while you’re fast asleep

I lie here alone in the darkness and weep.

So sorry and sad but that’s part of the deal,

When the tingle becomes a chill.

After 12+ years of engineering a monetary tingle unlike anything seen in the history of American finance, the Fed’s restrictive stance is settling in and with it the realization that the funding environment might be chilly for a while. There are still a lot of voices anticipating a recession and a return to more accommodative Fed policy. But long rates have been rising, yield curves have flattened some, and there is a noticeable increase in the number of articles in the financial press advancing the prospect of sustained high rates. Against these trends—and especially as monthly inflation prints have moderated—there is a vocal cohort suggesting the Fed should adopt a more flexible inflation target, shifting from defining success as inflation at 2% to success being inflation somewhere between 2% and 3% with the understanding that it's OK if we take our time getting to the lower end of the range. Remember, the Fed has a dual mandate (price stability and maximum employment), and it’s the growth-employment group (the tinglers) that is suggesting the Fed should pay less fealty to the price stability group (the chillers).

If you’re one of the many healthcare leaders that have been out of the capital markets over the last 12+ months, today’s funding environment will seem starkly different from what shaped earlier capital structure decision-making. As organizations start turning attention back toward external capital, it is important to assess what a sustained higher rate environment might mean. A few threads to explore with finance teams include:

1. The value of tax-exempt financing. In low-rate environments, tax-exempt versus taxable ratios tend to compress, increasing the appeal of the more flexible (use of proceeds perspective) taxable options. As rates move higher, ratios tend to widen back out, which can make tax-exempt financing significantly more appealing. Of course, tax-exempt financing has restrictions that may make it ill-suited to current capital investment needs, but the relative value this market offers may be compelling and should be understood.
2. The breadth and depth of funding markets. The hallmark of the “tingle” era was generally deep fixed income markets, sprinkled with periods like 2020 and 2021 that offered extraordinary liquidity and execution. This has changed, and a core consideration is whether key funding channels are broad-deep-resilient enough to handle meaningful flow. The question is reliability, and it applies to markets as well as intermediaries.
3. The reemergence of capital structure risk. For an extended period—and especially from mid-2020 to late 2022—the capital structure bias was de-risking via the issuance of natural fixed rate debt. As rates move higher, the idea of taking capital structure risk (i.e., issuing floating rate debt instead of fixed) should reenter the conversation. Two framing questions will guide this assessment:
   • Are the available rewards (lower cost or increased flexibility) compelling enough relative to the embedded risks (cash flow volatility or event risk)?
   • How do capital structure choices fit into the total enterprise return-risk matrix? Is it better to spend risk capacity in a debt portfolio or direct it to investments or operations?
4. The importance of financial intermediaries. For many organizations, taking capital structure risk requires credit or liquidity support from a financial intermediary (typically a bank). While the initial bank crisis was thought to have been contained, bank ratings remain under stress and pressures may escalate if higher rates or other factors erode bank capital cushions. The reliability of intermediaries should be part of capital structure risk discussion.
5. The return of structured products. Swap-based structures will become more compelling as rates move higher, and especially if “natural” markets or credit-liquidity intermediaries become less reliable or expensive. As an example, at certain points a put bond paired with a fixed receive swap can produce a more attractive floating rate cost-risk position versus a “traditional” bank supported option. Structured products carry their own reward-risk dynamic, and for many organizations the risks may prove too great. But the imperative is to test thinking, reexamine products with an open mind, and make an informed decision as to whether there is any role for these strategies in managing your debt position.

We advocate that every organization build and maintain a “responsive” balance sheet, which is one that continuously repositions balance sheet resources such that they wrap around the financial claims embedded in an organization’s operations and strategy. Pursuing the goal of a responsive balance sheet doesn’t eliminate the need to be tactically opportunistic when it comes to financing or investing products. The threshold strategic consideration is how much risk capacity to allocate to balance sheet (is it just the residual left after addressing operations or is imbalance tolerated in the pursuit of greater returns?). The tactical consideration becomes which balance sheet strategies provide the best return on allocated risk. For much of the past 3+ years the generic balance sheet playbook was to de-risk the debt portfolio and lean on less liquid/higher risk investment strategies as the reward engine. As rates move higher, both the debt and investment parts of the responsive balance sheet equation might shift, and getting to the right position will require doing the work to reassess which tactics are available, which make the best contribution, and what is the priority of implementation. The danger is always transactional thinking in isolation; the path is to apply that same transactional thinking inside a strong decision-support framework.