Farmers are in good shape regarding debt

Sep 9, 2011
by DTN

Borrowers can benefit from the economy’s anxiety! Interest rates are at historic lows, with 10-year Treasuries bouncing under 2 percent in intra-day trading in recent weeks and closing at levels not seen since the 1950s. But spreads suggest the market—if not the Fed— expects inflation and interest rates to rise, albeit not immediately, and not by a huge amount.

In the four Corn Belt states served by Farm Credit Services of Mid-America, 20year farm mortgages are running under 5 percent.

“There are a couple of things farmers should probably consider in this environment, Kansas State University Ag Economist Allen Featherstone told DTN. “They may want to consider refinancing given the recent decline in rates. In addition, this would be a time that they may want to consider locking in rates if they have not already done so. Finally, if they choose to use credit for land purchases, it may be useful to consider longer-term loans at fixed rates.”

Featherstone says that the stable rates promised by Fed eral Reserve Chairman Ben Bernanke’s last couple of talks are factored into the market. However, he isn’t willing to bet they wouldn’t change should inflation raise its head: “I somewhat doubt whether the Fed would hold the line on interest rates for as long as they say if inflation suddenly increased,” he told DTN. “It is a vote and the last vote was not unanimous. The last Fed meeting and Bernanke’s talk last week have not changed my thinking.”

Based on an analysis of Treasury yields, Featherstone noted: The market expects somewhat higher interest rates in the future; it expects inflation to rise, but only by about one percentage point.

First, Featherstone plotted five-year and 10-year Treasury bond yields. The spread between them has widened since the financial crisis hit, reflecting uncertainty in the longer term, Featherstone said. “Right now, we are seeing the greatest difference in 50 years, and I think it will increase further.”

Next, using an analysis approach called “Fisher’s Theory,” he deconstructed the rate on Treasury Inflation Protected Securities (TIPS) to back out inflation and read what the market expects.

“Again, breaking 10-year Treasury yields into zero to five years and five to 10 years, we find that the longer-term rate has a premium,” he said. “The short-term rate is about 1 percent while the longer term rate is over 4 percent— three percentage points higher. That spread ranged from plus 1 to minus 1 in the mid- 1990s and 2 percentage points during 2001 through 2006, then narrowed to zero for a year or two.”

The chart of five-year and 10-year TIPS shows that through 2006 and 2007, both time periods traded at about the same yield, between two and three percentage points over inflation, said Featherstone. Then when the crisis hit in October 2008, the fiveyear spiked to four percentage points over inflation.

“Now, it has collapsed below zero. In other words, traders are paying to hold the money. The longer-term fiveto10-year yield is more stable, trading in a 0.5 percent to 1 percent range. The widening range is at least partly due to an expected higher cost of borrowing a few years out.”

“For the zero- to 5-year time period, inflation expectations are for a return to the 2 percent area that we’ve seen for a long time, after its collapse in late 2008-2009,” Featherstone said. “Looking out at six to 10 years, the market sees 2.75 percent. So the spread is inflationary, but to the tune of about 1 percent.”

Cost of farm debt

Except for a brief period in 2008 when Farm Credit was painted with the same brush as the other governmentsponsored enterprises such as Fannie Mae, Wall Street’s stampede to “safe” investments has been good news for Farm Credit System borrowers.

One-year and five-year Farm Credit bond rates are a measure of the cost of farm debt. In the past two-and-ahalf years, we have seen a fairly large divergence, Featherstone said. The oneyear rate is about 1/3 percent, while the five-year is in the 1 percent to 2 percent range. “That puts the five-year Farm Credit rate at about half a percentage point more than a T bill,” said Featherstone.

The yield on Farm Credit bonds has decreased, and the risk premium for ag lending has been fairly constant and is at historically low levels, he said. “In fact, the spread between one-year Treasuries and Farm Credit bonds sometimes goes negative. In other words, people prefer to invest in agriculture.”

Farmers are in good shape regarding debt, Featherstone also found. Capital debt repayment capacity is greater, debt-to-asset ratios are lower, and working capital (debt/ assets) is in better shape this year. All those measures add up to less likelihood of default—which already was low.

Featherstone analyzed those measures for each farm in the Kansas Farm Management records from 1973 through 2010—1,200 to 2,000 observations per year—and plotted the resulting probability of default. From 1.5 percent in 1973, it rose to 3 percent in the mid-1980s and has fallen back to 1.8 percent or so now.

“We have seen an improvement in liquidity,” agreed Paul Ellinger, University of Illinois agricultural economist.

One measure Ellinger uses is the ratio of working capital to sales. “We like to see farms holding capital equal to at least 25 percent of their annual sales. It was 26 percent last year,” he said. “And unlike the general population, many of whom have seen the value of their house fall from 70 percent of their equity to zero, the components of farm equity have been relatively flat the past five years, with working capital equal to 36 percent, farmland 46 percent, and other assets such as machinery, 18 percent.”

So, given today’s credit situation, in general, farmers appear to be in good financial condition that allows them to take advantage of historically low rates in growing their business. — DTN