A Matter of Shipping Interest

Interest rates are on the rise. The Fed recently increased the so-called Fed Funds Rate by 0.25% and two more increases are boringly expected within 2018. There had been two increases in 2017 for a total of 0.50%, thus, in two calendar years, interest rates moved up by 1.25%. The Fed Funds Rate stands at 1.50% at the time of this writing, which is materially below the historic average. The 2yr Treasure Bill yields appr. 2.27% while 10yr Treasuries yield 2.80%, at the time of this writing.

In the short term, the US economy seems to be approaching full employment, and the risk of inflation (and higher interest rates) cannot be ignored. Of course, there are still many events, emanating both from the US and the international stage, that can affect economic growth, trade, employment, and the course of interest rates. Excluding a major shock to the system, it can be taken as a given that interest rates are on the rise for the foreseeable future.

Higher interest rates and higher interest cost can be good for regulated banks, but it can be detrimental to industries that depend on cheap financing to thrive. The shipping industry, we can all agree, is a capital intensive industry as it requires big investments upfront for the acquisition of shipping assets, and the cost of financing is crucial for the success of a shipowner.

Higher interest rates logically should be a negative development for the shipping industry: for higher cost of necessary leverage (ship mortgages) directly affects the bottom line – and, there are few shipowners who can do without leverage.

There have been few headlines in the shipping / maritime trade press about the higher interest rates. Not sure whether the news has been underestimated, or whether the shipping finance industry is so dislocated at present that rising interest rates are of little concern to the industry, but the subject has almost gone un-noticed.

Traditionally, debt financing in the shipping industry has been obtained from shipping banks in the form of first preferred ship mortgages, at LIBOR (the short-term interbank rate) plus the so-called spread, the lender’s profit margin. Interest rates obtained from shipping banks have varied over time depending on market conditions (interest rates, etc) and also the banks’ own appetite to expand their shipping lending business which has varied through business cycles. Although the loan from a shipping bank was “floating”, as the total interest rate varied with the changing-over-time LIBOR, the hedge desk from the same shipping bank would arrange – at the request of the client, of course – for an interest rate hedge / swap, so that the borrower could hedge, at the time of the loan inception, the interest rate risk. One has to note that the absolute interest rate was depending on two main factors, overall lending market conditions (LIBOR) and the banks’ appetite for shipping risk (spread), and these two variables were not necessarily in sync at all times. The other noteworthy observation is that a shipping bank was offering full service solution to the client, both the shipping loan and the hedge for the interest rate risk.

In the last several years, it’s widely known that shipping banks have been withdrawing from the shipping industry (anyone remembers the Royal Bank of Scotland (RBS) or even Lloyd’s TSB?), and credit funds have been moving into the shipping lending market. Given that institutional investors are behind such funds with higher return hurdles, the cost of borrowing from credit funds is much higher than that of the shipping banks. Still, credit funds express their interest rate offers in terms of LIBOR plus their spread over LIBOR, with usually the spread ranging in the 6-10% band. As a matter of comparison, traditionally shipping banks were (and, to the extent still active today, are) lending at 1-4% spread.

Reflecting… Image credit: Karatzas Images

No-one can blame the credit funds for being so expensive as their capital base is much different than that of a bank. [And, many would argue that shipping banks were mispricing risk and offering too cheap loans in the first place, but that’s a topic beyond the scope of this article, valid point nevertheless, in our opinion.] Also, no-one can blame credit funds that are not full service financial providers as they do not offer interest rate hedging, and shipowners / borrowers have to source it independently from banks, not an easy undertaking in today’s market when banks are disinterred in the shipping industry or in ad hoc clients and projects. The bottom line is that all ship mortgages and other debt financing instruments and transactions taken place via institutional investors are not hedged and most are fully floating and exposed to the rising interest rate environment. The cost is not inconsequential as 1% increase in interest rates reflects $27 per diem higher interest cost per each million borrowed; for a typical panamax bulker with a $10 mil mortgage from a credit fund, the 1.25% Fed rate bump in two years (included the expected twice in 2018) reflect $320 per diem additional daily financing cost, all being equal. For reference, the Baltic Exchange’s most recent report has BPI time-charter equivalent at $12,011 per diem (which incidentally is much higher than last year). $320 per diem incremental financing cost when the ship earns $12,011 per diem is not negligible, and this is still under an environment of well-behaving financial (and stock) markets presuming very rosy outcomes and being “priced to perfection”.

The shipping finance market is materially dislocated at present and the step-wise increases of interest rates by the Fed are a small problem to have in a much more challenging market. The concern however is that rising interest rates is a headache the market is ill prepared to deal with at present, and given that many borrowers (and lenders) are already stretched, there is minimal room for error. Anecdotally, we are aware of a couple of cases where shipowners trying to replace their 8% spread from credit funds with new financing, and not because they have expectations for lower interest rates.

It’s been a while since the shipping industry has been moving from one ring to a lower ring in what in business is called “vicious cycle”, when strategic errors keep compounding, further driving companies and the industry deeper into Dante’s Inferno.

Higher interest rates, in all likelihood, would push institutional investors and credit funds to increase their spreads as well, as now, in a new interest rate environment, their expected returns have to increase as well. Credit funds may theoretically opt to compete with each other on price (spread) in order to gain market share, or possibly decide to curtail their lending activities in shipping, neither option being a great outcome for the shipping industry.

Rising interest rates is not a laughing matter for the shipping industry, especially for the shipowners who went on the limb to borrow expensively in the hopes of out-running the business cycle. We would expect more news (and honestly more advisory work) from these developments.

Calm seas but not calm shipping… Image credit: Karatzas Images


© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

 

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Boats of the Highly Levered Seas

There used to be a time when the financing options for a shipowner where simple: seed capital was levered with a ship mortgage from a bank, and the loan was paid off based on an agreed-upon principal repayment profile from the operating profit. The terms of the shipping loans from banks were very similar and often the only differentiating factors for shipping loans were a few quantitative factors, principal among them the so-called spread, the difference over Libor for the cost of the debt.

Obviously, for any rational borrower, the lender with the lowest cost (interest rate) would get the business. When all things were equal, it was easy to note the sole differentiating factor, and push for the lowest number. Borrowers (shipowners) did not really have to create an “indifference curve”, their optimal set of choices. The leverage was in the 60-70% of FMV, the terms and covenants comparable, and thus the choices were limited. The “product” was one-dimensional and business was earned on the lowest spread.

Now that we live in times where by necessity there have been more types of capital than seed capital and traditional debt, such as alternative capital, mezz, senior and junior debt, etc, there is a greater opportunity to see the choices of preference for the shipowners.

There are funds that provide senior lending at only 500 basis points (5%) over Libor, but they do so at rather conservative terms, such as by lending in the 50-60% range of the FMV in today’s depressed asset pricing market environment. We would think that such financing is both cost competitive (in absolute terms) and also acts as prudent financial gearing for an owner to maximize returns and stay flexible when market conditions turn bad.

On the other hand, there are funds that provide close to 80% leverage, or even more, but at much higher cost, typically in the 8-12% range plus expectations of profit sharing, etc. The financial gearing is almost as sizeable as in the go-go days of the stratospheric market of a decade ago, but such levels of financial gearing add a lot to the costs of running profitably a vessel, and also multiplies the risk that when markets turn bad, the whole financial structure will not stand for more after the first few waves of the crisis reach the beach.

The options outlined above are as distinct as they can get, and although there are a few shades of gray between these two opposites, borrowers (shipowners) seem to gravitate to either of these polar opposites in terms of debt financing. And, watching shipowners make choices in the present market offers some insights on he direction of the market, the utility curves of the shipowners, their willingness to pay at various ranges of the curve, their risk appetite or risk aversion, and the inflection points thereof.

Even after the debacle of the last decade and the massive decade and rather fair prospects looking forward for shipping, there is a clear trend whereby shipowners prefer the high leverage, high cost (and high risk) option set over the low leverage, low cost (and low risk) alternative. There are many more shipowners who would rather borrow 80% of the value of a ship at 8% (spread) interest than shipowners who would borrow 55% at 5% (spread) interest. Credit funds and lenders in the former category are much more active than lenders in the latter camp.

Stephen, the Roaring Lion. Image credit: Karatzas Images

Apparently, shipowners (borrowers) seem to think that this is a time for “risk on” investments and thus higher financial gearing (at higher cost) makes sense. Asset prices, in the dry bulk market especially, are up by 30-50% on average in the last eighteen months, and thus, allegedly a high stakes strategy has paid off. Improving world economies and trade, and a historically low newbuilding orderbook add more fuel to the argument. But, playing the proverbial devil’s advocate, adjusted for risk, is a 50% asset appreciation investment justified on an 8% cost of debt?

In general, over the last decade, cost of capital (mostly debt) is going up in shipping. Interest rates have gone up, especially when they are expressed in terms of spreads. And, leverage overall has come down in shipping in the last decade. Likely, when shipowners (borrowers) are slowly adjusting their financing cost expectations, they seem to focus more on (and prefer) higher gearing at the trade of cost. In a theoretical binary choice of “give me more leverage or give me lower cost”, they are for the former, hands down. It may be that it takes a lot of time for habits to die?

High leverage at high cost has its risk, as mentioned. Already there are several transactions in the market where borrowers have already run into trouble and they desperately look to refinance high-priced transactions based on this structure. There are ships that have been arrested or are very close to arrest, ships financed with high leverage at high cost. And this is at a time when 2017 and 2018 freight rates are dreamboats of the 2015 and 2016 monster freight markets. Thus, in a relatively decent freight market, these high leverage preferences do not seem to always work out very well. We are afraid that after the debacle of private equity investments in 2011/2014 going sour in a major way and resulting in massive write-downs, the industry is setting itself up for another round of misguided investments powered by institutional money.

Shipping is a unique industry with its high volatility and risk at an operational level as this can be counted by the spot freight market (in the last eighteen months, BDI has been up by a factor of 5 but down 40% in the last month or so). Financial gearing over operational gearing can easily get out of hand.

But again, how fortunes have been made… or…

Stitt, the Quiescent Lion. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

Is the Dry Bulk Tramp Shipping Industry at an Inflection Point?

As punishingly brutal as the shipping industry can be in bad times, it’s fulfillingly rewarding in good times. Who can forget the days from a decade ago when capesize bulkers were earning $250,000 per diem and the ships themselves were changing hands in excess of $150 million? We are a long way from those good old days but memories of and even hopes for prompt arrival of great times keep many a shipowner persevering in this business. It’s known that sweet memories and often hopes have on occasion been used to spruce up many “investment theses” in investment presentations.

The dry bulk tramp trade – whereby ships do not sail on a fixed schedule or published ports of call – has long been considered a textbook case of perfect competition in economics with its low barriers to entry and exit, minimal government and regulatory interference and taxation, an international market of price-takers for an un-differentiated product where no individual player – whether shipowner or charterer – has controlling influence on the market.

In such an individualistic market environment, fortunes have been made – and occasionally lost – when independent shipowners took timely risks and positioned their companies favorably on the dramatic upswing of the business cycle. Now that the dry bulk market is closer to the bottom than the peak of the cycle, there are calls to take risks for a market upswing.

Probably the timing is opportune for buying bulkers in expectations of an upswing in the market but one has to consider whether the dry bulk tramp market still is a market adhering to the rules of a perfectly competitive market. The last decade has seen many fundamental changes in the market that one has to wonder whether the old playbook is still working.

The greatest barrier to entry the shipping industry has been capital, given that this is a capital intensive industry. However, in past times shipping banks were providing generous financing in terms of financial gearing (leverage) and covenants, and even there have been cases of “name lending” and financing agreed on a handshake. Now that shipping banks have been departing the industry, and with the capital markets veering away from project finance and commodity shipping, private equity and other institutional investors have been depended upon to provide capital to shipping but at a much higher cost of capital, tighter terms and covenants and often for a share of the economics. The barriers to entry in terms of accessing capital have definitely been affecting the industry in an adverse way, in this respect.

In reference to government interference and regulation, for vessels having open registries (flags of convenience), the burden is still low in comparison to other onshore industries, but one can see the writing on the wall of higher regulation (and higher costs.) Emissions and the quality of bunker fuel have been making headline news in the last year resulting in both a higher financial component to the business and also technological and regulatory risk. Likewise for ballast water treatment plans, past the official deadlines, technology and approvals only now are getting sorted out. Likely, there will be higher risks for safety and security and ensuring that ships and the seaways supply chain are supported by hack-free systems (ransomware NotPetya have cost Maersk a few hundred million in losses in their last quarterly report, while the possibility of “hacked” ships became a prominent scenario in a recent wave of collisions involving US Navy ships in the Pacific.) And, while offshore registered vessels are taxed on the so-called “tonnage tax” system, many revenue-challenged jurisdictions and taxpayers have been taking a second look on the substantial differential in taxation in reference to domestically registered shipping companies and the potential loss of revenue. Taxation is a risk routinely mentioned in the prospectuses of all publicly listed companies in the US-capital markets and that the current favorable treatment by the IRS cannot always considered to be “a sure thing”. Thus, in an increasingly burdensome era of regulations (environment, safety, security, etc) and taxation, another of the legs of perfect competition seems challenged.

In theory, the “product” that dry bulk shipping companies “sell” is a “commodity” and “interchangeable” as all dry bulk shipping companies offer the service of transporting cargoes in bulk over the sea; as simple as that. And, although there are many charterers who only care for the basic good of cheap transport, an ever increasing number of quality charterers demand more than the “basic” service of transport: they demand quality ships and proper management systems and real time reporting and accountability, and also solid shipowners and managers free of financial risk of default. Thus, the “product” of the tramp dry bulk shipping slowly becomes less commoditized and more of a “service” whereby now ships and shipowners are not exactly interchangeable. Quality ships run by quality managers are preferred by charterers, but they still earn market price; and, in order to be profitable at market prices, critical mass of a fleet is required in order to access capital and also spread the overhead among a larger number of vessels. Thus, another tenet of the perfect competition model that dry bulk is a “commodity” good is slowly challenged.

At the end of the day, dry bulk shipowners in the tramp trade are “price takers” and will take what the market pays as there is little pricing power; again, a perfect competition characteristic. However, the case of just buying cheap ships and wait for the market to recovery will not necessarily hold true in this new market environment. One has to wonder whether the tramp dry bulk market, as a precursor to other asset classes – is slowly approaching an inflection point where “value added” services would be a differentiating factor.

“Hope is a good thing, maybe the best of things, and no good thing ever dies”, as the quote goes, but one may has to start thinking that just hope alone of a market recovery similar to recoveries in previous business cycles may not be the case.


Article was originally was published on The Maritime Executive under the title “Is The Dry Bulk Tramp Market at an Inflection Point?” on December 1st, 2017.


Dry bulk vessel about to go under a bridge. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.