International Debt Instruments

Debt management, whether at the domestic or international level, is part of the company’s armoury of techniques which is designed to maximize the present value of shareholder wealth. It is often speculated that the key determining factors are as follows:

The amount of business risk affecting the firm.

The ability of the firm to service debt, in terms of interest payments and capital repayments, under varying scenarios regarding future outturns.

The limits imposed by financiers’ lending policies and practices.

The perceived norm for the sector.

The firm’s historic track record in terms of debt raised and the volatility of its earnings.

Beyond the debt / equity ratio, there are a number of factors include maturity profile, fixed / floating interest mix, interest rate sensitivity and currency mix.

Long-term assets should be funded by long-term finance; short-term assets would logically be backed by short-term funds. In terms of maturity profits of debt, the treasurer is well advised to ensure that repayments of borrowings are evenly spread. This reduces exposure to repayment vulnerabilities, which may be magnified due to unforeseen recession.

Short-term debt is riskier than long-term debt. Long-term interest rates are generally more stable over time then short-term rates. The firm which borrows predominantly on a short-term basis may experience widely fluctuating interest rate payments. Short-term borrowings have to be renewed regularly.

The interest rate on a fixed rate loan is fixed for the entire life of the loan regardless of changes in market conditions. A floating rate loan is one where the interest rate varies in line with the market. The loans are usually made at an agreed margin over a published market rate. This may be a clearing bank’s base rate for sterling or prime rate for US dollar, or LIBOR (London inter-bank offered rate) for term loans whether in sterling, dollars or Eurocurrency, and so on.

(A) Short-Term Borrowing

Short-term debt is defined as borrowings originally scheduled for repayment within one year. A wide range of short-term debt finance is available.

Trade credit is the major source. In its normal transactions, the firm buys raw materials on credit from other firms. The debt is recorded as trade creditors in its books of account. This is a customary aspect of doing business in most industries. It is a convenient and important source of financing for most non-financial companies.

The next most frequent form of short-term finance, at least in the UK, is the overdraft. An overdraft is a credit arrangement whereby a bank permits a customer to run its current account into deficit up to an agreed limit. The overdraft is flexible and is for providing seasonal working capital. Bankers like to see overdrafts run down to zero at some point during the year. Nowadays companies tend to finance some of their core borrowing needs by overdraft. The overdraft borrower is at liberty to operate within the established limit and to repay and redraw any amount at any time without advance notice or penalty. The interest charged is usually on an agreed formula, such as between one and four or five percentage points above the bank’s base rate. The size of this spread depends on the credit rating of the borrower.

Turning now to money-market sources of short-term debt, the domestic sterling inter-bank market provides a source of corporate borrowing. In this market, the corporate customer obtains very competitive borrowing and deposit rates. The interest rate is usually based on a margin over LIBOR. Large companies may obtain funds at LIBOR or at a very small spread over LIBOR. Transactions are for fixed terms, which can be anything from overnight to twelve months.

Sterling eligible bills – or bankers’ acceptances are bills of exchange and they are the oldest instrument in the UK money market. The purpose of the UK bill market is to provide trade finance. Acceptances are issued on a discounted basis. Clearly, the true cost of borrowing is higher than the nominal discount rate. If the discount rate plus commission is quoted as 15 ½ per cent, this amounts to a true rate of interest of well over 16 ¼ per cent. The procedure for companies wishing to use this market is to discount the bills with an accepting bank. The bill will be discounted at the eligible bill rate. The accepting bank receives an acceptance commission for discounting the bill. The bank pays the proceeds of the discounted bill to the company’s bank account. Once the accepting bank receives the bill, it will endorse it. The bank may either hold it for its own trading purposes or rediscount it with a discount house. On maturity, the company – or its agent – pays the face value of the bill to the holder at that firm.

Another source of short-term funds is borrowing via commercial paper – basically an IOU. Since April 1986 there has been a market in sterling commercial paper. This paper is in the form of unsecured promissory notes. Its duration is from 7 to 364 days. There are strict rules about which corporations can, and cannot, issue sterling commercial paper. The virtue of this market to the company is endorsed by the fact that a top rate corporation may raise money at around five basis points below LIBID, the London inter-bank bid rate, which is, of course, always less than LIBOR. Unlike US commercial paper, credit rating is not a prerequisite of issue in the UK. The greatest source of short-term funding in the USA is commercial paper.

Medium-Term Borrowing

Medium-term debt is defined as borrowings originally scheduled for repayment in more than one year but less than ten years. Until about fifteen year ago, European corporate treasures had few options when seeking to raise debt – the opportunities included overdraft or short-term bill discounting and long-term debentures and mortgages. This range of choice was poor compared to that confronting the treasurer in the USA, where there has always been an array of medium-term finance available. The expansion of US banks in the international arena aided by the colossal expansion of the Euromarkets and the widespread demise of exchange controls have meant that these financing techniques have been exported to European companies.

Nowadays, medium-term borrowing facilities are widely available. Repayment schedules are negotiable but the usual practice is to require periodic repayments over the life of the loan. The rationale of amortization is to ensure that the loan is repaid gradually over its life in equal instalments commensurate with corporate cash generation rather than falling due all at once. Medium-term loans are normally priced on a basis related to LIBOR. The spread over LIBOR depends on the credit standing of the borrower and the maturity of the facility. They normally vary between 0.25 and 2 per cent.

There are two types of fee associated with medium-term facilities. First, there is the commitment fee. The bank is usually committed to lend once the loan agreement is signed. This commitment fee is usually payable for the portion of the loan which is undrawn. The size of the fee may be ten to fifteen basis points.

When the facility is arranged via a syndication of banks, it is normal for the borrower to pay a management fee. The fee is similar to underwriting fees associated with public issues.

Euromarkets

Euro-dollar or Euro-currency markets are the international currency markets where currencies are borrowed and lent. Each currency has a demand and a supply in these markets. Thus, dollar deposits outside USA or sterling deposits outside UK are called off-shore funds and have a market so long as they are convertible and readily usable in international transactions.

Euro-currency market is a market principally located in Europe for lending and borrowing the world’s most important convertible currencies, namely, dollar, sterling, DM, French franc, yen, etc. On the same basis, the Asian currency market or the African currency market can also be defined.

The Euromarkets are usually defined to include the markets for Eurocurrency, Eurocredits and Eurobonds. The Eurocurrency market is that market in which Eurobanks accepts deposits and make loans denominated in currencies other than that of the country in which the banks are located. Eurodollars is that they are dollars held in the form of time deposits in banks outside the United States. Euro-Deutschmarks are marks deposited in banks outside Germany. The prefix ‘Euro’- really means external and refers to funds that are intermediated outside the country of the currency in which the funds are denominated. The Eurocurrency market is made up of financial institutions that compete for dollar time deposits and make dollar loans outside the United States, plus IBFs, financial institutions outside Germany that bid for Deutschmark deposits and make Deutschmark loans, financial institutions outside the UK that bid for sterling deposits and loan sterling, and so on.