What happens when cheap debt comes due?

Cheap debt can buy a company years. Then the bill comes due.

A company that locked in a low fixed rate may see little change in its interest payments as borrowing costs rise. The real test comes when a bond matures and the company needs to borrow again. How much can it repay on its own, and what will it cost to borrow the rest?

Byron Anderson, Head of Fixed Income at Laffer Tengler Investments, raised the broader issue in his Oct. 30 appearance on RFD-TV’s Cow Guy Close. He pointed to growing pressure on weaker companies that had relied on low-cost borrowing. Two hypothetical borrowers show how that pressure can play out.

Two companies, two refinancing decisions

The first company generates steady cash flow and has bonds maturing over several years. When the next bond comes due, it may be able to pay down part of the balance and refinance the rest. A higher rate would raise its borrowing costs, but it would apply only to the debt the company replaces.

The second company has less cash coming in and a large bond due within a year. It may need to replace most of that debt in a single transaction. If lenders demand a higher rate, interest could eat up more of the cash the business generates. Paying down more of the balance would reduce the amount it needs to borrow, but it could also leave less cash for payroll, inventory or equipment.

Both companies face the same credit market. The first can weigh its options over several years. The second may have to take the terms it can get before the bond comes due.

What we examine beyond the interest rate

How much comes due, and when? We look at the dollars due each year. Several smaller maturities can give management time to respond. One large payment can put much of the financing decision on a single date.

How much cash can the business spare? We look at cash on hand and what the business generates after covering operating expenses and necessary investment. A company may have enough cash to make a payment and still be stretched afterward.

What can management do today? It may be able to refinance early, pay down part of the balance or defer discretionary spending. Each choice has a cost. Refinancing early can mean accepting a higher rate sooner. Using cash to repay debt can leave less room to handle a setback.

Cheap debt bought both companies time. What matters now is how much of that time they still have and what they can do with it. The company with steady cash flow and staggered maturities can decide how much to repay and when to return to the market. The company with a large payment looming may have to borrow on whatever terms are available, even if the new interest bill leaves less cash to run the business.

For a bondholder, that difference matters well before the maturity date. A company can make every interest payment on its old debt and still face a difficult refinancing. When we assess a bond, we look at how the company plans to repay the principal and how much room it has to keep operating if the next round of financing costs more than it expected.