Managing in a rising interest rate environment

After previously labeling the current spate of rising inflation as “transitory” and due mostly to pandemic disruption, market participants now appear to be viewing the condition as more persistent. Recent headlines have called out a 7% increase in the consumer price index (CPI). The question has shifted from whether the Federal Reserve will increase interest rates and adjust its balance sheet to how soon and how much? Presently, the market is expecting three to four Federal Reserve rate hikes this year, as well as a gradual elimination of its asset purchase program.

U.S. Treasury (Treasury) bond pricing began anticipating rate increases late last year, with the 30-year bond climbing nearly 30 basis points (BPS) in December. While municipal bonds were initially slow to react and ended the year largely stable, rates have been on an upward climb since the beginning of the year, with the 30-year Municipal Market Data (MMD) rate climbing 14 BPS in less than two weeks.

Could the country be entering an extended period of rising interest rates? Perhaps. Therefore, now is the time to prepare by considering how local governments managed in past periods of elevated interest rates.

Tips for managing in a rising interest rate environment

1. Stay calm. What the media generally reports as a substantive increase in interest rates often does not translate into giant leaps in debt service costs. Keep in mind that a 50 BP (0.5%) rate increase costs an additional $5,000 per year on $1 million in debt, which is unpleasant, but not earth-shattering. It is also important to remember that inflation cuts both ways. Yes, we’re seeing rising costs. However, a robust housing market has increased the tax base for many communities and currently the expectation is that growth in real estate values will continue into 2022. While many state and local governments operate under limits on how quickly property can be reassessed and how much an annual tax bill can increase, the current trend should be expected to bolster governmental balance sheets for years to come.
2. Be patient. With supply chain disruption increasing the cost of steel and other construction materials, many communities are experiencing large capital improvement cost increases. If your entity can accommodate a project delay, it may be in your favor to wait out this period of construction market turmoil. Additionally, the American Rescue Plan Act of 2021 (ARP) and the Infrastructure Investment and Jobs Act (IIJA) provide exceptional grant funding opportunities for capital projects. Though it will take time for the federal government to implement these grant programs, get your projects “shovel ready” and monitor opportunities closely so you can be one of the first through the door when these program applications open. Keep abreast of the latest news related to these programs by subscribing to Baker Tilly’s state and local government alerts. For example, Treasury recently released its ARP Final Rule, which substantially reduced the reporting burdens and expanded the applicability of these funds for local government use.
3. Know your need.  An inflationary environment is no time to borrow money based on an uncertain knowledge of project costs. There are a variety of mechanisms that can be employed to protect against costs exceeding the amount borrowed. Your financial advisor can guide you toward the solution that best fits your project, such as guaranteed maximum price contracts and leveraging temporary or short-term financing. The best place to borrow in a rapidly rising or elevated interest rate environment is at the front end of the yield curve where rates are the lowest. This is why we have historically seen substantial increases in short-term and variable rate municipal borrowings in past high rate periods (and, incidentally, why we have seen virtually none of these products for the past ten plus years).
4. Plan for various scenarios. We live in a period of rapid change. In the “old days,” a government entity could prepare one long-term financial plan based on a single set of assumptions and sleep well at night. Today’s disruptive economy requires multiple financial plans based on varying assumptions and the flexibility to make adjustments part-way through the process. Now is a good time to run sensitivity analyses for anticipated projects to be financed with debt. This will inform how much of an interest rate increase the project can accommodate and still work within the financial plan. It is also an opportune time to consider ways to diversify the sources in your project’s “capital stack.” While traditional, long-term fixed-rate tax-exempt debt remains the easiest and most obvious option, examining sources such as grant monies, short-term or variable debt and private or commercial capital through the implementation of a public-private partnership (P3) structure can all help create hedges against current market volatility.

Rising interest rates certainly make financial and operational environments more challenging. But proactive strategy, a composed mindset, level-headed decision-making and collaboration with your municipal advisor will help local governments succeed, just as it has in the past.

For more information, or to learn how Baker Tilly Municipal Advisors can help your government, contact our team.

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