Funding Strategies in a Rising Interest Rate and a Flattening Yield Curve Environment
In our third article Special Issue on Growth and Innovation Niso Abuaf suggests that an optimal corporate funding strategy may be a “barbell” that combines short-term borrowings (to exploit still low short-term rates) with some long-term borrowing to lock in historically low interest rates against the possibility of rising inflation and interest rates. Abuaf shows that a “barbell” funding strategy is on the “efficient frontier” of corporate liability structure, i.e., the curve tracing the lowest cost and lowest standard deviation points. Such strategies consist of a barbell with occasional medium-term borrowings, but with some “rollover” or funding risk attached.
Once the efficient frontier has been delineated, the chief financial officer can use breakeven analysis to choose the optimal maturity mix. The choice between fixed and floating interest rates will depend upon management’s tolerance for earnings fluctuations resulting from moves in short-term rates.
While most of the existing literature predicts that a lot of short-term debt leads to early default, Abuaf sees that an upward sloping yield curve can easily make short-term debt cheaper than longterm although it comes at the cost of higher volatility. It follows that in a flatter yield curve environment, longer maturities may be more attractive. If a company’s revenues are highly correlated with short-term rates, it should keep maturities relatively short, however.
If, as Abuaf thinks most likely, that interest rates increase 100 basis points across the curve, CFOs should lengthen maturities now.
Authored by Niso Abuaf, Pace University and Samuel A. Ramirez and Co.