3

I was reading about the debt to equity ratio on Investopedia and in third paragraph under the "Modifications to the Debt-to-Equity (D/E) Ratio" title, it says that:

"If interest rates fall, long-term debt will need to be refinanced, which can further increase costs. Rising interest rates would seem to favor the company with more long-term debt"

This seems very contradictory to me? Shouldn't this be the opposite instead? Rising interest rates would mean that debt capital cost more as the company needs to pay higher interest on its outstanding debt?

Follow up question: Can someone also explain

"If interest rates fall, long-term debt will need to be refinanced, which can further increase costs."

why does the existing long term debt needs to be refinance? What qualifies as a long term debt?

CountDOOKU
  • 334
  • 2
  • 12

2 Answers2

5

The cost of your existing debt is fixed; it stays the same no matter how interest rates change. It's only new debt that is affected by the current interest rate.

Rising interest rates means your existing debt costs less to service than your competitors' new debt.

Lower interest rates means your existing debt costs more to service than your competitors' new debt.

Since the assumption is that companies never actually eliminate their debt, only continue to pay off old debt or acquire new debt, then you come out on top when your competitors have to pay more for their debt than you pay for yours.

Regarding "long-term debt will need to be refinanced": there's no law that requires you to refinance. But remember we are comparing your costs to your competitor's costs as a way to measure how successfully you are competing. If you don't refinance, you are definintely not decreasing your costs. If you do refinance, you are probably decreasing your costs, as long as the up-front cost of refinancing isn't more than what you would save in interest payments.

IMO, the sentence in the quote is poorly worded. It seems to imply that you have to refinance, and that do so has a good chance of increasing your overall costs. (I could be wrong, but I would think that the costs of refinancing would rarely exceed the interest in savings. But I have no personal experience with the type of corporate debt being discussed, only personal home mortgages.)

chepner
  • 4,506
  • 1
  • 22
  • 25
0

Long-term debt (bonds) has higher duration than shorter-term debt, i.e it's more sensitive to interest rate changes.

Since debt issuers are short duration, as opposed to debt holders, they benefit from rising interest rates.

As a consequence, issuers of long-term debt benefit more from rising interest rates than issuers of shorter-term debt.

When interest rates fall, companies who fail to refinance their debt pay higher interest than current market rates, which isn't optimal. However, refinancing isn't free as existing debt needs to be bought back or called, and new debt needs to be issued, which comes with fees.

0xFEE1DEAD
  • 9,353
  • 2
  • 23
  • 31