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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Credit is due to Shipping Finance

The freight market has been disappointing recently, for dry bulk, tankers and containerships, while asset prices too have been on a softening trend, especially for tankers. As one would expect, traditionally the freight market gets most of the attention in shipping, for signs of strength with the hope that asset prices would be lifted too; however, we are of the opinion that shipping finance may be the key for successfully navigating the shipping markets going forward.

Having traveled extensively recently and having closed several S&P and structured, financial transactions, we can only be more convinced by the day that shipping finance is where the real battlefield lays for shipping nowadays. Access to finance, whether based on own funds or access to financing from third parties, is what sets shipowners apart in terms of survival and growth.

Shipping banks are done with traditional shipping and first preferred ship mortgages. Yes, we have seen a couple of occasions where European banks are still lending at 300 bps spread over Libor, but they are so selective and have such a limited capacity that effectively such lending activity only confirms the fact that shipping banks are not active for most practical purposes. Thus, cheap debt financing is no more.

Shipping credit funds have made lots of noise in the last year, and we estimate that they have deployed close to a billion dollars in the last eighteen months; still, they are too afar from financing the average shipowners, notwithstanding the temptation in this desperate market for debt financing. Credit funds typically look for 8% minimum yield before any fees, equity kickers and other incentives, which limits their applicability to only second hand vessels that are priced at a multiple of the collateral’s scrap value; financing the acquisition of a resale capesize vessel with excess $30 mil acquisition price and paying 8% yield, one may as well try their luck in Las Vegas and try to have a good time while they are at it. Thus, credit funds can have parodical application.

Private equity funds having made ill-timed “bets” in 2011-2014 in shipping (and we consciously use the term “bets”), now they stand licking their wounds and trying to devise ways to cut their losses short. Never mind grandiose plans for IPOs, market consolidation and bringing turn-around expertise and making a commitment to the industry; we have been the busiest we have seen with advisory, market intelligence, valuation, industry expertise services for disputes, arbitration and litigation between shipowners and financial investors. So much for hopes that private equity could feel the funding gap left in the wake of shipping banks leaving the industry.

True, there are still shipowners with deep pockets who have kept buying vessels well into 2017, despite the asset price bounce compared to all time lows in 2016 for the dry bulk market; however, there are few shipowners that indeed still have deep pockets. German owners may feel sick that they lose ships to other markets and especially to the Greek market, and this can be true to an extent, but on the other hand, few shipowners have been buying and can keep buying on a sustainable basis; most shipowners with ‘seed money’ are almost maxed out and looking for third-party money if they were to keep buying.

Shipping finance is really the battleground for modern shipping these days, the industry’s ‘soft underbelly’. While one can keep projecting on tonnage demand growth and developing trade patterns, shipping finance will be the field that will make or break shipowners. Shipping finance is getting to be ever more challenging and there is no realistically any reason that the picture will get brighter in the future. Yes, for few publicly listed shipping companies with critical mass, real business plans and solid corporate governance, capital markets can still be the way to go. But for most of the independent shipowners and several of the penny-stock listed shipping companies, shipping finance would be the critical link in their survival and / or success.

Based on reports from a recent shipping conference in New York – which purposefully we did not attend, we have seen that “M&A” and “consolidation” were the buzzwords of the day. But again, in a market that is as dead in activity as a coffin floating after the sinking of the „Pequod” in Moby Dick, whether for IPOs, etc (even a SPAC sponsored by the blue blood Saverys’ shipping family has failed) or follow-ons, hopes for “M&A” and “consolidation” have to do. And, statements that shipping and commercial banks ought to be considering shipping again, given that the industry is “low volatility”, humored us for reminding us the proposed “Hamburg Formula” for vessel valuations  of almost ten years ago where the shipping industry was suggested to be an industry of low volatility and risk and the suggested cost of capital was a whole of 50 basis points over the T-bill, then.

Solving the shipping finance riddle is really a critical point for most of the shipowners to address going forward, the direction of the freight and asset pricing markets.


This article first appeared on Splash 24/7 on June 23rd, 2017, under the title “Credit is due to Shipping Finance”.


Manhattan, New York City: An ever more critical place for shipping finance. 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.