Be Prepared!

Be Prepared!

Business owners today can take their strong balance sheets and earnings to senior banks or other capital providers to begin discussions on improving their borrowing terms. To be recession ready, ask for:
  • Longer term commitments,
  • A lender with flexible principal repayment terms,
  • Safety capital to have on hand for a rainy day

Recession Indicators

The term spread, defined as the rate difference between the US 10-year and 1-year treasury, is frequently cited as an indicator for recession. In the past 60 years, recessions have occurred within two years after a negative term spread 90% of the time, the term spread is trending steeply downwards.

Figure 1. Relationship of Yield Curve and Recessions
9 out of 10 times in the past, recession happens within 2 years after term spread turns negative
Sources: Federal Reserve Bank of San Francisco – Economic Letter: March 5, 2018
To quantify the probability of a future recession, economists have created statistical models based on the term spread, asset valuation, term premium and r-star (the natural level of real interest rates). As of February 2018, the estimated recession probability is rising on a steep incline toward the Critical threshold.

Figure 2. Probability Model for Recession
Statistically, among all factors, term spread matters the most to test Recession
Sources: Federal Reserve Bank of San Francisco – Economic Letter: March 5, 2018
Companies may now be enjoying strong earnings, and be comfortable making debt repayments and financial covenants.  In a prior publication, we discussed how rising interest rates could affect a company’s ability to make its debt service payment. Similarly, during a recession, consumer purchasing declines, which affects a company’s profitability to service its debt. At the same time, banks become more conservative, causing a contraction in the overall capital availability.

How can business owners be prepared?

Business owners today can take their strong balance sheets and earnings to senior banks or other capital providers to begin discussions on improving their cashflows:
  • Longer term commitments: most of Canadian loans are due on demand; therefore, business owners should try to renew their loans for a longer commitment period or renew the facilities to reset the clock.
  • Flexible principal terms: lenders that offer principal skips or long amortization terms or terms with optimal repayments rather than straight line repayment.
  • Safety capital: business owners should save extra cash or develop relationship with alternative credit or private equity firms who can provide safety capital.