Debt financing is an important topic for treasury professionals to understand due to the impact of debt usage on profitability and firm value. Most of this section will cover this topic in a general framework, with some specific information provided on issues for US-based organizations. The major differences between countries are in the interest rate measures used and some specific regulations related to the credit and debt instruments.

Interest rates depend on many factors. Some of these factors arise from general economic conditions, while others are dependent upon firm-specific variables (e.g., financial position, industry, overall debt use). To help form a basic understanding of these factors, the model below incorporates some of the most common factors into a calculation of an underlying interest rate on a specific debt issue.

For most borrowers, the underlying cost of debt (expressed as the variable r in the calculation below) is a function of the following factors:

Where:

The real risk-free rate of interest is generally defined as the rate demanded by lenders (i.e., investors or savers) to compensate for delaying purchases made today, in the absence of any risk or inflation, for a one-year maturity. The real risk-free rate demanded by savers becomes the basis for the overall borrowing rate. Historically, the average real risk-free rate was approximately 1.2% between 1980 and 2016. At the time of writing, the real risk-free rate is at or close to zero in most major markets, due to long-term government intervention to lower rates. The US T-bill rate (less an adjustment for short-term inflation) is sometimes used as a proxy for a real risk-free rate of interest due to the US government’s backing for the T-bill and the instrument’s relative liquidity in the market.

The first adjustment to the real risk-free rate is for inflation, as lenders want to maintain the purchasing power of the money they lend to borrowers. The sum of the real risk-free rate and the inflation premium (IP) is commonly referred to as the nominal rate.

The next adjustment is for default risk. For investments other than some government securities,²² there is a risk of default on the part of the borrower that must be factored into the rate of interest. This is known as the default premium (DP). As the level of default risk rises, so does the required interest rate.

While the markets for most securities issued by some governments, including those issued by the US government, are very efficient and highly liquid, other securities are not as easily traded, resulting in higher transaction costs and, ultimately, lower liquidity. This results in a liquidity premium (LP).

Finally, longer-term fixed instrument investments generally have more price risk (i.e., they fluctuate more in price for a given change in interest rates). As a result of this price risk, longer-term securities usually have a maturity premium (MP) in addition to the other interest-rate adjustments.

To illustrate these concepts, Exhibit 13.5 shows the interest rate components for three basic types of notes or bonds: US Treasury issues, corporate issues, and municipal issues. Each type is shown with varying maturities. The rates displayed here are for illustration purposes only and are not necessarily representative of actual rates or spreads between different types of investments. In calculating the rates for each type of investment, the following assumptions are made:

• US Treasuries are perceived to be risk-free, with no default risk.
• US Treasuries are highly liquid and thus have no liquidity risk.
• Both corporate and municipal bonds have default and liquidity risk.
• Maturity risk increases with the issue’s time to maturity.

This information is combined to calculate the total cost of borrowing for each investment type, which is shown in the final column of Exhibit 13.5.

The impact of the various factors on the required rates for different types of bonds is shown in the exhibit. For example, for bonds with a one-year maturity, the T-bill rate is 0.5%, the corporate issue has a rate of 3.5%, and the municipal rate is 3.0%. The T-bill incorporates only the inflation premium as an adjustment to the real risk-free rate, while both the corporate and municipal issues reflect some amount of default risk and liquidity risk. Comparisons of the rates across the five- and ten-year maturities also show T-bills with the lowest rate, followed by municipal bonds and corporate bonds.

For most borrowers, the cost of funds is expressed as the sum of a base rate plus an appropriate adjustment or spread to account for other risks involved in the arrangement. The base rate will generally include the adjustments for inflation and maturity premiums, while the spread will factor in adjustments for the default and liquidity premiums. The difference between the common base rates discussed below and the T-bill rate is that the rates below are essentially interbank rates (i.e., the rate at which one bank will lend to another bank). The interbank rates will be slightly higher than the T-bill rate at any given time due to a small amount of default risk inherent in bank-to-bank borrowing arrangements.

Economic conditions and yield curves influence the general level of interest rates and base interest rates for borrowing. Historically, LIBOR has been the most important base interest rate, with the Fed funds rate and the US prime rate also being important benchmark rates in the United States.

The ICE Benchmark Administration (IBA) compiles LIBOR daily by averaging the interest rate quotes of at least eight banks chosen to reflect a balance by country, type of institution, reputation, and scale of marketing activity. LIBOR is quoted in numerous currencies and is released to the market in London each day. LIBOR’s replacement means it will be phased out as a benchmark rate over time,²³ to be replaced by new benchmark rates in the key global financial centers (e.g., LIBOR is likely to be replaced by SOFR in the United States and ESTER in the eurozone).

The Fed funds rate is the interest rate US banks charge to borrow reserve balances from one another. The target rate for Fed funds is set by the Federal Open Market Committee on a periodic basis (about eight times per year), but the actual rate charged between banks is negotiated by those banks. This is known as the Fed funds effective rate. The US prime rate is the interest rate commercial banks charge their best corporate customers, although strong, creditworthy borrowers usually can obtain rates below prime from their financial partners. Unlike LIBOR, which fluctuates on a daily basis, the US prime rate is typically set about three percentage points above the Fed funds rate and can remain fixed for extended periods of time.

Historically, short-term interest rates are lower than long-term rates, so yield curves are usually normal, meaning they slope upward with maturity. This implies that there is a cost advantage to using short-term credit. When short-term rates are higher than long-term rates, the yield curve is inverted and slopes downward with maturity.

A significant responsibility for treasury professionals is to monitor interest rate cycles and the yield curve, in order to make effective decisions about short- versus long-term financing. Depending on interest rate cycles and the prevailing yield curve for interest rates, a company may secure long-term, low-rate bank or institutional financing and/or obtain fixed- versus floating-rate financing. There are also several short-term financing sources (e.g., accounts payable and accruals) that have little or no interest costs.

Borrowing on a short-term basis carries two types of risks to the borrower that are avoided in longer-term borrowing:

• The first risk relates to fluctuations in market interest rates. If the company borrows on a short-term, floating-rate basis, then it will borrow at the prevailing interest rate and risk dramatic rate swings in either direction. Such short-term borrowing risks can be reduced via interest rate caps, collars, swaps, and floors.
• The second risk of short-term financing concerns the availability of funds. If a company relies heavily on short-term borrowing, then the short-term funds may not be available at some future point due to tightening credit standards on the part of lenders. Also, a firm’s credit quality may decline, thus endangering the future rollover or renewal of the credit arrangement. Some companies counter this risk by negotiating multiyear credit line commitments (e.g., revolving credit agreements), which guarantee the availability of funds over a longer term.²⁴

In contrast to short-term borrowing, long-term borrowing on a fixed-rate basis stabilizes interest costs and provides funds for a longer term. However, stabilizing interest rates over a longer period exposes the borrower to a risk of a fall in interest rates, which would materialize as higher interest costs than those faced by any competitors borrowing on a shorter-term basis.

1. Operational Advantages of Short-Term Financing

It is important to understand the advantages and disadvantages of short-term financing (i.e., credit facilities of less than one year) relative to long-term financing (i.e., credit facilities of at least one year). Aside from differences in cost and risk, there are operational differences in using short- versus long-term debt to finance current assets.

The primary operational advantages of short-term financing include ease of access, flexibility, and the ability to efficiently finance seasonal credit needs. In addition, short-term loans generally have less restrictive covenants than long-term loans because a lender’s funds are at risk for a shorter period of time. A short-term borrowing arrangement allows the borrower to maintain flexibility for future borrowing decisions. For example, to meet increased seasonal needs, a firm may need financing to increase inventory and/or accounts receivable. Short-term loans are a primary tool for financing seasonal (i.e., temporary) increases in current assets.

In addition to bank credit, short-term financing can also be obtained from spontaneous sources such as accounts payable and accruals, which are referred to as spontaneously generated financing. As sales grow, these sources spontaneously generate funds that can offset required investments in current assets.

2. Operational Disadvantages of Short-Term Financing

An operational disadvantage of short-term financing, especially sources such as lines of credit or commercial paper, is the continuing need to renegotiate or roll over the financing. This rollover risk is a disadvantage as a lender may decide not to roll over the loan or renew the credit line at maturity due to changes in the borrower’s financial conditions or changes in general economic conditions. In addition, lenders that provide lines of credit typically require that loans used to finance short-term working capital deficits be paid in full for a minimum period of one to three months each year.

Many firms find that using short-term loans to finance permanent current asset requirements is risky. However, one approach to continued use of short-term debt that carries lower risk involves revolving loans secured by accounts receivable or inventory, referred to as asset-based lending. The downsides to this form of secured borrowing include the following:

• The assets used as security must be monitored and are not available to secure other borrowing or as a comfort when seeking unsecured borrowing.
• Key ratios related to the assets must often be maintained.
• Lending is generally limited to some percentage of the asset values.
• Secured borrowing takes management time to negotiate.

Loan covenants, discussed earlier in this chapter, impose either restrictions, known as restrictive or negative covenants, and/or obligations, known as affirmative or positive covenants, on the borrower. Loan covenants generally protect the lenders by preventing management from increasing the borrowing entity’s credit risk, thereby reducing the value of existing debt securities. Because the lenders do not typically have a voice in the entity’s management, they must protect themselves through covenants at the time the loan is made. For bonds, the covenants are typically determined from negotiations with the rating agency as part of the ratings process. The covenants may impose significant restrictions on the entity’s financial decision making. These restrictions could include limits or restrictions on the:

• Ability to sell certain assets
• Right to issue additional bonds
• Use of second or junior mortgages
• Key ratios for the firm
• Payments made by the firm (e.g., dividends)

It is also important to understand that the terms of the loan agreements and covenants are generally negotiable between the borrower and the lender. The advantage that the borrower has is that it usually has a better idea about the amount of the line that will be used, as well as how often it will be used. In general, if only a small portion of the credit line will be used, then it would be advantageous to agree to a higher interest rate in return for a smaller commitment fee. If, on the other hand, the borrower thinks it will be using the bulk of the line, then a lower interest rate may be negotiated in return for a higher commitment fee, assuming the commitment fee is on the unused portion of the line.

In many cases, a multiyear revolving credit agreement may be counted as long-term debt on the firm’s balance sheet, which can reduce the level of current liabilities, thereby improving key ratios (e.g., the current and quick ratios).

²² Although securities issued by many governments, including the US government, have low default risk, some government debt has a much higher risk of default, especially if the security was not issued in the government’s domestic currency, such as government debt issued in USD by non-US governments.

²³ The Bank of England and the UK Financial Conduct Authority will not require the calculation of LIBOR beyond 2021.

²⁴ During the global financial crisis of 2007–2009, many banks rescinded these guarantees using material adverse change (MAC) clauses. As the crisis continued, banks primarily offered credit agreements of less than one year in length, as the capital requirements on these agreements were lower than those for multiyear credit agreements.