Fixed-Rate Versus Floating-Rate One of the first questions a corporate treasurer seeking to borrow via a

Fixed-Rate Versus Floating-Rate One of the first questions a corporate treasurer seeking to borrow via a

bond offering must address is whether to issue a floating-rate or fixed- rate bond. Issuers of floating-rate bonds fall into one of two categories.

The first are financial entities whose assets that they invest in pay a floating interest rate. For example, suppose that a bank makes loans where the interest payment it receives is 3-month LIBOR plus 300 basis points. If the bank issues fixed-rate bonds, the risk that it would take is that 3-month LIBOR may increase to a level where the interest payment it receives from the loans may be less than the fixed rate it pays to bor- row funds. A properly designed floating-rate bond eliminates that prob- lem. If the bank can borrow funds on a floating-rate basis where it pays, for example, 3-month LIBOR plus 30 basis points, then the bank is earning a spread of 270 basis points—the difference between 3-month LIBOR plus 300 basis points it receives from the loans and 3-month LIBOR plus 30 basis points it pays to bondholders. If 3-month LIBOR increases or decreases, the bank has locked in a spread.

The second type of issuer of floating-rate bonds is a corporation that does want to lock in a fixed-rate bond but issues a floating-rate bond. Why does a corporation take on the risk that market interest rates will rise in the future and therefore it will have to pay a higher interest rate? One possibility is that the corporation will benefit if inter- est rates go down and that is the expectation of the chief financial officer. Typically, that is not the reason. The reason is in fact that the corporation ultimately does not take on the risk that interest rates will

Intermediate and Long-Term Debt

rise. This is done by combining the issuance of a floating-rate bond with the use of an interest rate swap. We introduced the basic elements of an interest rate swap in Chapter 4. An interest rate swap allows an issuer to change floating-rate payments into fixed-rate payments. By doing so, the issuer of a floating-rate bond who simultaneously enters into an interest rate swap in which it receives a floating rate and pays a fixed rate has synthetically created a fixed-rate bond. This is because the floating rate that the issuer receives pays the bondholders of the fixed- rate bonds that it issued. We will illustrate how this is done in shortly when we discuss how swaps are used in conjunction with designing a bond offering.

Economic theory tells us that if markets are efficient then whether a corporation synthetically creates a fixed-rate bond by issuing a floating- rate bond and using a swap or by just issuing a fixed-rate bond, the cost of funds will be the same to the issuer after transaction costs. Therefore, why not just issue a fixed-rate bond? The answer lies in an understand- ing of how markets operate.

In the real world, institutional bond buyers impose constraints on the amount that they will invest in a particular issuer, or in fact, issuers in a particular sector of the bond market. Suppose a corporation has historically issued only fixed-rate bonds. When this corporation is con- templating a new bond offering, the chief financial officer will approach its investment banker about how much it will cost to raise the target amount of funds. The sales force of the investment banking firm will canvass its bond customers to assess what it will cost the issuer to issue

a fixed-rate bond. Suppose that the banker’s sales force indicates that most fixed-rate bond buyers are not willing to purchase any additional fixed-rate bonds issued by this corporation because it has realized its maximum exposure. This may mean a higher cost for issuing the bond. The sales force, however, may indicate that institutional buyers of float- ing-rate bonds will be more receptive to the corporation since they do not have any credit risk exposure to the corporation. The investment banker would then determine what the cost of a synthetically created fixed-rate bond issue will be if the corporation issued a floating-rate bond and used an interest rate swap. If the cost is lower, the corporation may issue the floating-rate bond. Even if the cost is close to the same, the CFO may decide to synthetically create a fixed-rate bond just to increase its presence in the floating-rate market.

It is for the same reason that corporations needing to issue bonds with a floating rate will issue a fixed-rate bond and enter into an interest rate. In this case, the corporation will agree to pay a floating rate and receive a fixed rate, thereby synthetically creating a floating-rate bond.

FINANCING DECISIONS