Shipping is a capital-intensive industry, which is heavily dependent on debt financing. LIBOR (the primary benchmark for short-term interest rates globally) has started to increase at a faster pace over the past five months compared to prior increases witnessed as of the end of 2015. In December 2015, 3-month USD LIBOR stood at 0.54%, reaching a level of 1.61% in December 2017, only to further increase to 2.35% at the end of April 2018. Typical mortgage-backed shipping finance transactions bear USD LIBOR plus a spread, which on aggregate constitute the main interest expenses of shipping companies.
The uptick in USD LIBOR is starting to show its colours in the financial performance of shipping companies and weighing in on their profit and loss statements. The ones with a clear disadvantage are the ones with high levels of debt -either due to borrowing from their banks at high points in the cycle or financing on the back of vessels with fixed employment which employment has discontinued. Smaller companies who do not enjoy fleet diversification are prone to concentration risk. If they are in an underperforming sector, the elevated interest cost amounts to a double whammy for their bottom line. Lastly, companies exposed to floating interest rates face a more immediate risk. Increases in USD LIBOR will also present additional problems on financially distressed shipping companies as vessel break-evens will again stretch vis a vis the earnings which they can command for their vessels, bringing them back to the drawing board with their banks for another round of difficult discussions.
Rising USD LIBOR comes at a time where the cost of capital of the banks is also increasing due to impending regulations – resulting in changes in ship finance lending spreads. The number of ship finance banks with active lending portfolios have reduced significantly – each with their own different costs of funding, margin policy, minimum pricing criteria, and internal rating systems. Subject factors are deemed to make it difficult for ship finance banks to reduce margins. However, what should be noted is that even in today’s ship lending environment the high calibre shipping companies with a proven track record can still command competitive pricing/spreads for their additional debt requirements from some ship finance banks (albeit fewer).
The emergence of various shipping funds in recent years has come in to fill the shipping banks’ finance void, albeit at substantially higher spreads and therefore shipping companies again face increases in their overall interest costs. However, some of these shipping funds do offer the option of fixed interest rate finance throughout the agreed term, which provides some visibility of the outlays over the finance period.
Similarly, another alternative which has become increasingly popular is lease financing. These structures also offer shipowners the option of fixed interest finance over the agreed lease period and again protect owners from potential fluctuations in interest expenses.
The OIS Libor spread represents a certain country’s central bank rate over the course of a certain period. For example, in the US an entity could potentially exchange a floating rate (the Fed Funds Effective Rate) with a fixed one, which is the OIS rate. The spread between USD Libor and the OIS rate has been widening since last year, causing some pressure on funding costs, a factor, which has triggered some concern in the market about a reminder of the financial crisis. Should this be cause for concern in the banking system? We don’t believe this should be cause for concern (at least for the near term). If one looks at the US, there has been a significant increase in Treasury bill issuance in the three months ending February 2018 compared to the same period in 2017 – a factor that disrupted short-term funding markets and is causing the LIBOR-OIS spread to increase. What has also kicked in is the recent tax cut in the U.S., prompting U.S. companies to sell their short-term paper in order to buy back stock and/or pay out dividends. These trends have therefore contributed to the rise in short-term funding costs. If one looks at broader financial conditions, credit is, in fact, easier to obtain today. If one looks at the Chicago Fed’s National Financial Conditions Index, one sees that financial conditions are easier currently despite the increase in USD LIBOR. Given that the aforementioned current supply and demand dynamics in short-term funding markets are the main catalysts of LIBOR-OIS spread we do not believe that this will have a wider impact on the ship lending market.
Although the impact of high-interest cost is being felt across all shipping segments, this recent development from the LPG segment is a good example of what is happening in practice.
When Navigator Holdings published its first-quarter 2018 results, the company’s interest expenses grew by 18% ($1.6 million, year-on-year), with 75% of this increase ($1.2 million) owing to the rise in the US Libor rate. The company had not hedged its interest exposure, however, has said that it might do so in the future.
There are several factors to consider here, namely;
Policy announcements by major central banks (especially by the US Federal Reserve) indicate that the interest rate is expected to rise in the future, which should further support the US Libor rate rise. Moreover, if inflation surpasses current expectations, further increases could be expected in interest costs.
However, interest cost is just one of the several factors that impact the earnings of shipowners, and the freight market in each sector will be the principal determinant of how much cash owners generate. That said, one thing is clear that higher interest costs, will only reduce the earnings of owners and not augment them.