Time to think about borrowing long?

Citation

Robinson, B. (2002), "Time to think about borrowing long?", Balance Sheet, Vol. 10 No. 3. https://doi.org/10.1108/bs.2002.26510cab.001

Time to think about borrowing long?

Bill Robinson

Bill Robinson is head UK business economist in Financial Advisory Services at PricewaterhouseCoopers, London. He is a former special adviser to the Chancellor of the Exchequer.

The late 1990s saw a remarkable boom in corporate bond issues, as optimistic companies sought to gear up the rate of growth of their expected profits. The stock market correction and the recession put an end to that. But as the first glimmerings of economic recovery become apparent, there is renewed interest in expanding the amount of debt on corporate balance sheets. There is a parallel and linked interest in exchanging short-term debt for long-term debt.

The arguments for borrowing long rather than short can be divided into two: the long-term strategic case for borrowing long is mainly about risk management within the business. The short-term tactical case is based on reading the economic cycle.

Strategic considerations

The slope of the yield curve

Take the strategic arguments first. Most companies that incur debt begin with short-term bank debt. It has a number of obvious advantages. First, it tends to be cheaper than long-term debt because the yield curve is normally upward sloping. According to theory this is because long-term debt is a risky asset – the capital value can change as interest rates change. The lender has to be paid a premium for bearing this risk. The theory is borne out by the facts. Figure 1 shows the history of US long and short interest rates. Long rates are normally (though not always) above short rates. More on that below.

Figure 1 Short rates are usually lower than long rates and both trended downwards since the early 1980s

"Some of their short-term loans turn into bad debts"

Another attraction of short-term debt for the borrower is that the firm avoids the expense of getting a credit rating. It just goes to its bank and negotiates a loan. But the other side of this is that the banks themselves have to make a living – and some of their short-term loans turn into bad debts. The banks' margins reflect these realities, which is why short-term bank debt is not always particularly cheap.

Cost of credit rating vs bank margins

Large businesses can avoid paying bankers' margins by tapping the bond market. Whether this is worth doing will depend, among other things, on the cost of obtaining a credit rating (a large, fixed, sunk cost). The pay-off from investing in a credit rating is a long-term saving in banker's margins. The firm can replace short-term bank debt with long-term credit from the bond markets, and replace the bank mark-up with a potentially smaller bond spread. The larger the amount of borrowing, the more this calculation will favour bond finance over bank loans.

Risk of non-renewal

The second great attraction of short-term bank loans is their flexibility. Loans can be increased or reduced in size according to the cash requirements of the business. However, this flexibility can be a two-edged sword. When a short-term loan becomes due, the banks will normally roll it over on demand. But if a business gets into trouble, the roll-over of bank credit is anything but a formality. The regular re-financing of short-term loans can become a major headache for any business in hard times. The business with long-term borrowings, whether negotiated with its bank or by issuing bonds, escapes these headaches. This is one reason why long-term finance is less risky for the borrower than short-term finance. (It is more risky for the lender, which is why the borrower pays a premium.)

Matching length of loan to asset life

This brings us to an important use of long-term finance, which is to match the life of liabilities (loans) to the life of assets. If some plant or equipment has a 20-year life, and can guarantee a stream of revenue over that life, then it makes sense to finance the plant with a matching loan. The stream of revenue is matched by a stream of payments which is designed both to meet the interest on the loan and to build up a repayment fund. The whole operation is then insulated from financial risk. This is the basic reason why bond finance is so popular as a means of financing large revenue-generating infrastructure projects (such as toll bridges and roads). There is also a growing trend towards bond-financed property vehicles, because properties with long leases can also provide a secure stream of revenue to set against the interest payments.

The main financial risk against which the business is insulated by these arrangements is a change in short term interest rates. The last two major recessions (1980 and 1990) were both sparked off by rising interest rates, subjecting firms to a double whammy of falling sales and higher interest costs. The firms with long-term borrowing at fixed rates of interest escaped the second half of this double whammy. Building in long-term finance at a fixed rate of interest can be regarded as a sensible insurance against an interest rate disaster of this kind. Like any insurance it involves payment of a regular premium (higher interest charges).

Tactical considerations

The economic cycle

So when is it worth taking out this kind of insurance? In the depths of a recession, when short-term interest rates are low because the authorities are seeking to stimulate a recovery, the yield curve may be particularly steep. Long-term finance looks an expensive option. Conversely, at the peak of a boom, when the authorities may be raising short-term rates to cool the economy, long-term finance may look relatively cheap. An examination of the chart shows that when short-term rates start to rise, long-term rates usually follow. The implication is that long-term borrowing, which seemed rather expensive in the trough of the cycle (because more expensive than short-term borrowing), may turn out to be an unrepeatable bargain (because short and long rates both rise as the economic recovery gets under way). Reading the macroeconomic cycle correctly can thus make a big difference to a firm's long-term borrowing costs.

Secular inflation trends

However the economic cycle is not the only relevant factor. Equally important is the long-term trend in inflation, which is what drives long-term interest rates. When inflation and long-term interest rates are trending upwards, most decisions to borrow long look good with hindsight. The problem is that lenders quickly recognize this and stop lending. The corporate debt market all but vanished in the inflationary 1970s. When inflation is trending downwards, most decisions to borrow look bad with hindsight. Borrowers lock in long-term borrowing, only to find they could have borrowed more cheaply had they waited. This is probably why the re-birth of the corporate bond market had to wait until inflation had stabilised at a low level.

Getting the timing right

For those who believe that stable low inflation is here for the foreseeable future, now is probably the moment to start considering replacing short-term debt with long,not least because corporate decision making processes can be quite slow. The upward sloping yield curve may make long-term borrowing look relatively expensive at present. But when short-term interest rates start to rise, as they surely will, the stampede to lock in long-term borrowing will drive up long-term rates. Today's apparently expensive long-term borrowing will then become tomorrow's unrepeatable bargain. Buy now while stocks last?