Interest Rate Market Timing – Finance Now or Later?

JPMorgan Chase CEO Jamie Dimon recently warned that a “very, very serious” mix of headwinds was likely to tip both the U.S. and global economy into recession by the middle of next year (2023). Among the indicators ringing alarm bells, Dimon cited the impact of runaway inflation, interest rates going up more than expected, the unknown effects of quantitative tightening and Russia’s war in Ukraine. His comments come at a time of growing concern about the prospect of an economic recession as the Federal Reserve and other major central banks raise interest rates to combat soaring inflation. In updated projections, the Fed signaled plans to lift rates by another 1.25 percentage points before the year is over, bringing the federal funds rate to 4.25-4.5 percent before 2022 comes to a close. Looking even further into the future, the Fed is bracing to lift rates to 4.5-4.75 percent by next year. Six officials, however, see rates soaring to 4.75-5.0 percent next year, which would be the highest since 2007 if it comes to fruition.^[1]“‘This is serious’: JP Morgan’s Jamie Dimon warns U.S. likely to tip into recession in 6 to 9 months”, October 10, 2022, Sam Meredith, www.cnbc.com

In a rising interest rate environment, the question often asked by public agencies with financing needs is, when is the right time to enter the market? Should financing be deferred for the prospect of lower interest rates in the future? Should financing occur sooner to avoid higher rates later? Because timing the market perfectly is nearly impossible, the best strategy for most is not to try to market-time at all. Instead, borrowing should be executed when agencies are ready to receive bond proceeds to construct the project(s). Deferring a financing subjects agencies to the risk of further interest rate increases. Accelerating a financing, if possible, may help to avoid market volatility and further increases in costs. Ultimately, however, the best time to borrow is when an agency has completed the proper planning and is ready to receive the proceeds.

Case Study

Incorporated in 1888, the City of Lake Elsinore (“the City) is in the Elsinore Valley of Western Riverside County on Historic Highway 395. Elsinore Valley is centralized with about an hour to two hours’ drive between major anchor cities such as San Diego, Los Angeles, Orange County, Palm Springs, and Big Bear. Serving a population of 64,762, the city limits fall on the Easterly shores of Lake Elsinore, the largest natural freshwater lake of Southern California. The growing City provides a range of municipal services for citizens throughout the community that include maintenance of 22 parks, 3 public beaches, fire prevention, code enforcement, animal services, planning and development, building inspections, licenses and permits, construction and maintenance of streets, right-of-way landscaping maintenance, traffic and street lighting, capital improvements, general administration, recreational services, cultural activities, and lake services.

Staff proposed, and the City Council approved, the expansion of the existing City Hall to address current needs and the future growth demands of the City. While various funding options were explored, lease revenue bonds were determined to be the most optimal method of financing. Due to the prospect of higher interest rates and rising construction costs, the City expedited the financing timeline to achieve the lowest possible cost. In June of 2022, the City successfully sold $23.7 million of lease revenue bonds, generating $24.1 million in proceeds to finance the new City Hall facility, financed over a 30-year term at a true interest cost of 4.57%. Shortly before the sale, the independent bond-rating agency, Standard & Poor’s, upgraded the City’s lease revenue bond rating by one notch from ‘A’ to ‘A+’. The improved rating also applies to the City’s 2016 lease revenue bonds, which were issued primarily to finance Launch Pointe Recreation Destination and an RV Park. As rationale for the upgrade, Standard & Poor’s specifically cited the City’s “rapid economic development,” “strong financial management policies and practices,” and “maintenance of a very strong general fund reserve position despite temporary pandemic-related impacts.”

A comparative analysis of tax-exempt bond yields between June and September of 2022 indicates that the City generated higher net proceeds ($1.3 million) by expediting its financing.  To highlight the changes in tax-exempt yields since June compared to September:

 

1-year yield has increased 134 basis points (+1.34%)

• 1.72% (pricing) to 3.06% (as of September 30, 2022)

30-year has increased 52 basis points (+0.52%)

• 3.38% (pricing) to 3.90% (as of September 30, 2022)

Yields across the interest rate curve have increased, on average, 56 basis points (+0.56%)

• Short-term yields (within 5 years) have been impacted the most

Suffice to say, issuing bonds with today’s higher yields could have resulted in less net proceeds for the City. Assuming that annual debt service payments are kept at $1.5 million (City’s targeted annual payment amount), it is estimated that the City could have generated approximately $22.8 million in net proceeds based on current rates, or roughly $1.3 million less than that what it achieved in June.