Interest Rates and BEAD

I’ve recently been working with ISPs who are getting worried about what high interest rates might mean for the upcoming BEAD grants. Interest rates keep creeping upward to levels we haven’t seen in decades. Just last week, I saw that home mortgages are now at 8% – and infrastructure loans are only a little less expensive.

For any ISP that was going to borrow most of the BEAD matching funds, the increase in interest rates can be devastating. When BEAD was first announced in 2021, I had clients getting infrastructure loans at 4% or less. There are banks now talking 6% to 7%, with a good possibility that the rates will be even higher next year when it’s finally time to make the final go/no go decision to participate in BEAD.

Except for some exceptions for high-cost areas, most BEAD grants will be capped at 75% of the cost of the infrastructure. However, the NTIA has given instructions to states to stretch BEAD dollars by rewarding applicants who will accept less than a 75% grant. This means that many BEAD applicants will be borrowing to cover more than 25% of the cost of the infrastructure.

BEAD applicants also have to finance other costs that are not covered by the BEAD grants. BEAD grants only pay for broadband-related infrastructure. The grants don’t pay for vehicles, computers, furniture, and any other similar assets. BEAD also doesn’t cover expenses, and a BEAD applicant must cover the labor and other start-up costs for launching a new market. These expenses must be supported by the ISP until revenues grow to cover operational expenses.

It’s hard to stress the importance of interest rates on the viability of a rural business plan. The areas where BEAD will be built are rural, by definition, and will not generate a lot of monthly cash, even when completed and mature. Many of the business plans I’ve reviewed barely cash flow with a 75% grant and the interest rates we saw in 2021. In many business plans, interest expense is one of the major expenses in the early years of the roll-out.

There is another BEAD issue that is also dependent on the interest rate. The guaranteed letter of credit will be more expensive as interest rates increase. For ISPs that will borrow the matching funds, the base loan and letter of credit are a double whammy.

ISPs have a tough choice to make. It seems likely that interest rates will not stay at the high levels we see today. Interest rates may still rise as the Federal Reserve continues the fight against inflation. But historically, high interest rates have always returned to lower levels eventually. It doesn’t seem likely that interest rates are going to drop as low as what we’ve seen in the last decade, since for much of that period the interbank lending rate was near zero.

The hard question for an ISP who is borrowing at high rates is if and when interest rates will drop and if they will be able to refinance BEAD loans. I’ve lived through periods in the past where borrowers faced this same dilemma. Borrowers need to be prognosticators and make some guesses about the future of interest rates. If an ISP believes that rates won’t drop enough to ever be affordable, it’s time to pass on taking grant funding. But if future refinancing seems likely, a borrower has to guess when rates may drop and become affordable.

Interest rates are another of the many BEAD issues that are going to force some ISPs to think twice about taking the grants. Higher interest rates don’t directly affect ISPs that are planning on using equity, but even that’s not entirely true since equity investors consider market financial conditions as part of deciding where to invest.

There couldn’t have been a worse time for the still-increasing interest rates for anybody considering BEAD. The hardest question to answer is what the interest rates might look like in 2025 and 2026 when most of the money will be drawn to pay for construction. If rates start to return to sane levels by then, then the situation will not be as dire as discussed above. But who has the crystal ball that will predict interest rates over the next three years?

Interest Rates and Grant Matching

I have a lot of clients looking at broadband grants that will require matching funds, and they are rightfully getting worried about the climb in interest rates.

Back when the upcoming BEAD grants were announced in November 2021, many of my clients had access to loans with interest rates in the range of 3% to 4%. The higher interest rates we are now seeing will clearly have a huge impact on the ability to afford accepting a grants to build in a rural area. Almost by definition, rural areas are sparsely populated and so it is always a challenge to cover any debt payments on grant matching funds.

Consider the following table that shows the annual debt payments that would be due for a $10 million loan for terms of 20, 25, and 30 years, at interest rates varying from 3% to 8%. This might be a loan for a $40 million BEAD grant where the grant applicant must cover the 25% matching cost for a 75% grant. The second set of numbers shows the percentage difference for each loan compared to a 20-year loan at 3%.

Interest Rate 3% 4% 5% 6% 7% 8%
20 years 672,157 735,818 802,426 871,846 943,929 1,018,522
25 Years 574,279 640,120 709,525 782,267 858,105 936,788
30 Years 510,193 578,301 650,514 726,489 805,864 888,274
20 years 100% 109% 119% 130% 140% 152%
25 Years 85% 95% 106% 116% 128% 139%
30 Years 76% 86% 97% 108% 120% 132%

The table demonstrates several things. First, big interest rate increases are a massive disincentive for an ISP to make new investments. If an ISP had a business plan last year to build a new project with a 3% loan, the debt cost has climbed 40% to 52% with a 7% or 8% interest rate. Since debt costs are one of the major expenses for building fiber, this kind of increase could easily kill expansion plans.

I know a lot of ISPs who are putting expansion plans on hold due to the interest rates. If an ISP decides to accept a high interest rate, it would only be due to a belief that the loan could be refinanced if interest rates drop. But many loans don’t allow refinancing for some fixed number of years. This is also gambling. In the past, when interest rates spiked like they are now, the rates have usually dropped back down – but there is never any guarantee that rates will drop back to the low levels of just a year ago.

This is a bigger dilemma when borrowing to match grants. Grant projects have completion requirements, and ISPs might be forced to accept a high interest rate loan due to the timing of construction. Building a grant project is different than normal planned expansion, where a project can be delayed waiting for more favorable interest rates.

One of the ways to offset higher interest rates is through longer loan terms. But that’s not always easily achievable. Many lenders don’t like making loans for more than twelve or fifteen years. It might not be easy to get a longer loan term. It’s also worth noting that one of the main consequences of banks raising interest rates is that banks start to pull back from making new loans. This may be counterintuitive, but the underlying interest rates that banks have to pay also increases when retail interest rates are higher. Higher underlying rates increase the risk and financial consequences of loan defaults. Just like home mortgages are harder to find when interest rates are higher, it’s possible that the banks that were willing to loan to grant projects might also back off.

The retraction of new debt is exactly what the Federal Reserve intends when it raises interest rates. The whole point of raising the rates is cool off an overheated economy – without going too far and causing a recession. It’s going to be a shock to at any ISP to find out that the bank it was counting on is less interested in lending to them.

Big ISP Risk Trends

BDO Global is an international firm that specializes in accounting, tax and financial services. They monitor a number of industries and recently published their 2018 Telecommunications Risk Factor Survey – their fourth annual survey. The survey asks the largest 60 worldwide telecom companies about issues that are decreasing or increasing their market risk.

While the issues identified in the report represent issues faced by the giant telecom companies (certainly would include AT&T, Comcast and Verizon), the findings are important because issues affecting the big telecom companies eventually filter downward to affect the rest of the industry.

There are areas where the big telecom companies are seeing less risk:

  • Reduced Regulatory Risk. Companies are seeing less regulation, something that is particularly true in this country. Since big telecom companies tend towards being monopolies, less regulation generally translates into higher prices and better financial performance.
  • Expansion of Markets. Big telecom companies worldwide are expanding into new product lines. Some are doing this by big mergers, such as Charter and Time Warner Cable. Others are moving into new fields – for example, all the large US ISPs have purchased companies to help them compete with Google for advertising revenues. The big US cable companies are now entering the cellular business. The quad play has now entered our vocabulary.

However, the big companies also see growing risk in some areas including:

  • Increased Competition. US cable companies becoming cellular providers is a great example, and they are putting downward price pressure on all US cellular providers. But competition is coming from many directions – companies like Netflix, Skype, VoIP providers and many others are chipping away at services traditionally provided by telcos.
  • Fast Arrival of New Technologies. The big telcos expressed concern about how quickly new competitive threats are able to make it to market. They see upcoming threats from new technologies like 5G and new satellite broadband networks. They see the proliferation of on-line content. They are generally concerned that new technologies are making it to the market more quickly than in the past and can quickly gain significant market share.
  • Interest Rates. Telecoms are expecting higher future interest rates. This is a big concern since telecoms generally carry a lot of debt and are more susceptible to interest rates than many other industries. Big telecoms have been borrowing heavily for mergers and acquisitions and often finance capital expansion – both which create long-term debt. The big telcos are worried that higher interest will restrict their capacity to grow.
  • Access to Financing. Big telcos see a tightening of the credit markets due to a general tightening of the banking industry, but also due to their own performance. Many telcos are seeing lower margins per customer due to cord cutting, the continued drop of landlines and increased cellular competition. They foresee bankers less willing to extend the same levels of debt they’ve had available in the recent past.
  • Foreign Currency Exchange Rates. Telcos that work in multiple countries, like AT&T, are concerned with fluctuating currency exchange rates which can quickly turn international profits upside down.

Overall the big global telecom companies are doing well today. These BDO risk assessment asks them to look out a few years into the future. The overall worries of the industry as a whole are a little lower in 2018 than in 2017. However, the industry is still far from being rosily optimistic and foresees some dark clouds looking over the future horizon.

If their fears become true, this represents both increased risk and increased opportunity for smaller competitive ISPs. Certainly a tightening of lending and higher interest rates hurt smaller companies even more than the big ones. However, anything that forces the big companies to slow down or retract opens up more competitive options for small companies who compete against them.

This is an interesting look into the near future and is something that is not much publicly discussed. Once has to assume that the big telcos have their own internal economic forecasts – although I’ve never seen a lot of evidence that they look forward much past the next few quarterly Wall Street earnings announcements.

Watching Interest Rates Again

eyeballWe have had an amazing run of stable interest rates. This has meant that I could create a business plan and have good confidence that the interest rate that I used would still be good a year or two later when it’s time to finance a project. That took one big worry off the plate because it hasn’t always been like this.

Historically interest rates have gone up and down and this period of steady rates is the exception in the way that interest rates have bounced during my career. Just within the last decade there were times where the bond markets were in such turmoil that it was nearly impossible to float new bonds. For the past few years we’ve seen nearly the opposite and the bond houses I know have instead been decrying the lack of bond deals wanting to get financed.

It’s not surprising to see interest rates starting to swing a bit again. We are going through a big stock market correction that has investors spooked. And the first thing that spooked investors affect is the bond market. The municipal bond market sells almost entirely to wealthy individuals looking for a safe haven for money. And corporate bonds are sold to both wealthy individuals and big pools of money like pension funds and insurance companies. As those buyers liquidate stock holdings there is a big increase in demand for bonds. Bank rates are the last to change, but they react over time to changes in the corporate bond rates.

Interest rates really matter to fiber projects. A project that might be feasible at a low interest rate might become risky at a higher one. I can remember times in the past when floating a municipal bond deal was dependent on the interest rate that was being offered on the day the bonds went to market. Bond sellers would hire experts who would try choose the right time to sell new bonds. And on the morning when a bond was to go for market I’d be sitting waiting to plug in the interest rate and bond term being offered that day to make sure it was a good deal.

I certainly don’t hope for a return to those kind of crazy times because high or fluctuating interest rates can put the kibosh on many good projects that would have easily been funded in better times. But since the payment term for bonds is so long the interest rate matters a lot – fiber bonds might last for 25 or even 30 years and might not be able to be called and refinanced for 10 or 12 years.

This blog was prompted by reading an article about the widening spread between corporate bonds and US Treasury bills. The spread for the whole corporate bond industry has opened up to 770 points, meaning that the interest rate being charged for issuing corporate bonds is a full 7.7% higher than the rate being paid on T-bills. That different climbed 1.1% just during the month of January. We haven’t seen a full 1% change in interest rates during a month for quite a while. More worry came when I just read that a Federal Reserve survey of banks shows that the majority of banks see a tightening of credit for 2016.

Why do interest rates matter to a fiber project? Consider a $50M fiber project. I just did a calculation of a project of this size for a client. In that project an increase of 1% in interest rate cut long-term cash flows by over $5 million if funded with bank debt. But if funded by municipal bonds the impact was $15 million due to the longer payment term plus the fact that muni bonds usually borrow money to make the first few years of interest payments up front. While a 1% change in interest rates might not kill a project, it’s easy to see that changes of more than 1% can be deadly.

Maybe worse of all is that we have been sitting with interest rates at historic lows for a long time. This means that the only place that rates can go is higher. At least, when rates finally go higher, there is always a chance that they might drop. So I will start keeping my eyes on news of interest rates again. It seems one of our old worries is back on the plate again after a nice hiatus.