Monday, October 10, 2011

Term Limits 3D

Imagine the situation where our CEO approaches us and says “why don’t we issue short-term debt so we can pick up some earnings per share this coming year?”
What factors need to be considered in order to assess this proposition properly and provide an appropriate recommendation? Roughly speaking there are three dimensions:
Risk
Refinancing – if the debt comes due at inopportune moments, when supply and demand are out of balance, the organization can face significantly higher funding costs.
Cash Flow Volatility – if our firm is subject to cash flow volatility, the choice of short-term or long-term debt can exacerbate this, depending on what factors cause the volatility and the correlation of the volatility to interest rates.
Investor Diversification – short-term debt investors and long-term investors can differ, so in aggregate it may be beneficial to diversify to capture the lower portions of each segments supply and demand curves.
View of the Future
Signaling Effect – if we are aware of information or opportunities that will positively impact the organization over the coming period of time, we may issue short-term debt now so that we can refinance later at better rates when these opportunities have come to pass and the information is public.
Funding Cost Strategy – short-term debt rates are usually (though not always!) lower than long-term debt rates, so by issuing short-term debt consistently our financing costs will be lower than if we financed at longer tenors.
Market Timing – if we have a view that rates are near their “bottom”, or are likely to rise, then we may execute longer term debt issuances in order to “lock in” the more favorable rates.
Flexibility – long-term debt may make the organization less likely to exploit future growth opportunities, since a portion of the value of these opportunities will go to existing debt investors.
Current Market and Financial Situation
Current Interest Rate Environment – short-term vs. long-term interest rates may be very different or very similar.
Current Credit Environment – short-term vs. long-term credit spreads may be very different or very similar.
Current Debt Structure – depending on our existing debt structure, such as existing “maturity buckets” and short-term vs. long-term mix, we may need to use an upcoming issuance to balance the debt from an aggregate viewpoint.
Current Asset-Liability Duration – the duration of the company’s liabilities to its assets may create a need to balance from this perspective. 
This list of factors is long. Different elements will be more important than others at any given time, and therefore we will see situations where two different companies execute completely opposite financing activities, or two people in the same company may have opposite opinions about which way to go. This is to be expected – this is not a decision that can emanate from a black box.
I would love to hear your thoughts about term structure of debt or your stories on this topic if you have them.
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3 comments:

  1. This is interesting. I hadn't really thought about why companies would weigh short term vs. long term debt. Good insight.

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  2. Maddie,

    Thanks for the comments. One of the things I thought of after posting this is that this topic is an area where some additional research could be performed. As you note, it is not the first thing people think of when approaching a financing decision.

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