A Long and Short Tern Debt

7/28/2019 A Long and Short Tern Debt

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How to choose between a long and short-term debtfund

By Ganti Murthy

Head, Fixed Income, Peerless Mutual FundManaging debt funds is not as glamorous a job as working with equity mutual funds, but it is an

important job nevertheless, especially when it comes to protecting the principal investment of

investors. Moreover, most debt funds are rated for credit quality by an external rating agency.

Debt funds ensure tax-free returns and lower the tax outgo when compared to other fixed income

instruments like fixed deposits etc. They are low-risk when compared to equity as most of them

invest only in the highest credit-rated debt paper. Debt funds can be broadly classified in two

types, long-term and short-term funds.

In debt markets and debt funds, the risk increases with a corresponding increase in maturity. The

longer the maturity of either the security or fund, the greater the risk of valuation loss, as longer

maturity securities lose more in value when interest rates rise. In such a situation how does aninvestor make a distinction between long-term and short-term funds and how does one invest?

In debt funds, investors can make good returns if they can time the movement of interest rates

properly. Investors then can make sizeable capital appreciation along with current income. In

case investors are looking for current income and principal protection, then short term funds offer

the least risk. But then how does one make a choice between short- and long term funds?

Investors need to ask three questions before making a decision to invest: What is the time

horizon; what is my risk appetite; and what is my investment objective?

The time horizon:

If the investor has a short-term time horizon, then a short-term bond fund or a money market fund

(liquid fund) would be ideal, as the capital would be protected and the investor can enjoy current

income without being bothered with the vagaries of the daily fluctuations of the bond market. If an

investor has a longer time horizon of a year and more, with a higher risk appetite to ride out the

vagaries of the bond market over a longer time period , then a long-term fund like an income fund

or a gilt fund would be ideal.

Risk appetite:

If you have a conservative risk appetite and abjure excessive risks, seek capital protection and

steady income, then a short-term fund would be suitable. Funds under this category would be

money market funds, ultra short-term and short-term bond funds which invest in short maturity

corporate bonds. On the other hand, an investor who seeks long term capital growth through the

strategic movement in interest rates and bond yields should aggressively invest in long-term bond

and gilt funds.

Investment objective:

What is the core purpose for which an investor seeks to invest in either long-term or short-termfunds. What is the investment objective? Is the investor seeking principal protection before taking

a view on markets? Or the investor wants aggressive growth? Answering these questions will

determine the path the investor will take while choosing long- or short-term debt funds. So, in

conclusion, the decision to invest either in short-term or longterm depends on the various factors

listed above. Investors would do themselves a great service if they list out their preferences and

objectives and then make an informed decision before investing their hard-earned money.


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Proportions of Short-Term and Long-Term Financing

Not only does a firm have to be concerned about the levelof current assets; it also has to

determine theproportions of short- and long-term debt to use in financing these assets.

This decision also involves trade-offs between profitability and risk. Sources of debt

financing are classified according to their maturities. Specifically, they can be categorized

as being either short-term or long-term, with short -term sources having maturities of one

year or less and long-term sources having maturities of greater than one year.

Cost of Short-Term Versus Long-Term Debt

Recall from Previous Chapter that the term structure of interest rates is defined as the

relationship among interest rates of debt securities that differ in their length of time to

maturity. Historically, long-term interest rates have normally exceeded short-term rates.

Also, because of the reduced flexibility of long-term borrowing relative to short-term

borrowing, the effective cost of long-term debt may be higher than the cost of short-term

debt, even when short-term interest rates are equal to or greater than long-term

rates.With long-term debt, a firm incurs the interest expense even during times when it

has no immediate need for the funds, such as during seasonal or cyclical downturns. Withshort-term debt, in contrast, the firm can avoid the interest costs on unneeded funds by

paying off (or not renewing) the debt. In summary, the cost of long-term debt is generally

higher than the cost of short-term debt.

Risk of Long-Term Versus Short-Term Debt

Borrowing companies have different attitudes toward the relative risk of long-term versus

short-term debt than do lenders. Whereas lenders normally feel that risk increases with

maturity, borrowers feel that there is more risk associated with short-term debt. The

reasons for this are twofold.

First, there is always the chance that a firm will not be able to refinance its short-term

debt.When a firms debt matures, it either pays off the debt as part of a debt reduction

program or arranges new financing. At the time of maturity, however, the firm could be

faced with financial problems resulting from such events as strikes, natural disasters, or

recessions that cause sales and cash inflows to decline. Under these circumstances the firm

may find it very difficult or even impossible to obtain the needed funds. This could lead to

operating and financial difficulties. The more frequently a firm must refinance debt, the

greater is the risk of its not being able to obtain the necessary financing.


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Second, short-term interest rates tend to fluctuate more over time than long-term interest

rates. As a result, a firms interest expenses and expected earnings after interest and taxes

are subject to more variation over time with short-term debt than with long-term debt.

Profitability Versus Risk Trade-Off for Alternative Financing Plans

A companys need for financing is equal to the sum of its fixed and current assets. Currentassets can be divided into the following two categories:

Permanentcurrent assets

Fluctuatingcurrent assets

Fluctuating current assets are those affected by the seasonal or cyclical nature of

company sales. For example, a firm must make larger investments in inventories and

receivables during peak selling periods than during other periods of the year.Permanent

current assets are those held to meet the companys minimum long-term needs (for

example, safety stocks of cash and inventories). illustrates a typical firms financing

needs over time. The fixed assets and permanent current assets lines are upward sloping,

indicating that the investment in these assets and, by extension, financing needs tend to

increase over time for a firm whose sales are increasing.

One way in which a firm can meet its financing needs is by using a matching approachin

which the maturity structure of the firms liabilities is made to correspond exactly to the life

of its assets, as illustrated in. Fixed and permanent current assets are financed with long-

term debt and equity funds, whereas fluctuating current assets are financed with short-

term debt.Application of this approach is not as simple as it appears, however. In practice,

the uncertainty associated with the lives of individual assets makes the matching approach

difficult to implement.

illustrate two other financing plans. shows a conservative approach, which uses a relatively

high proportion of long-term debt. The relatively low proportion of short-term debt in this

approach reduces the risk that the company will be unable to refund its debt, and it also

reduces the risk associated with interest rate fluctuations. At the same time, however, this

approach cuts down on the expected returns available to stockholders because the cost of

long-term debt is generally greater than the cost of short-term debt.

illustrates an aggressive approach, which uses a relatively high proportion of short-term

debt. A firm that uses this particular approach must refinance debt more frequently, and

this increases the risk that it will be unable to obtain new financing as needed.

In addition, the greater possible fluctuations in interest expenses associated with this

financing plan also add to the firms risk. These higher risks are offset by the higher

expected after tax earnings that result from the normally lower costs of short-term debt.


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Matching Approach to Asset Financing

Consider

again Burlington Resources, which has total assets of $70 million and common

shareholders equity of $28 million on its books, thus requiring $42 million in shortor long-


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term debt financing. Forecasted sales for next year are $100 million and expected EBIT is

$10 million. Interest rates on the companys short-term and long-term debt are 8 and 10

percent, respectively, due to an upward-sloping yield curve.

Conservative Approach to Asset Financing

Aggressive Approach to Asset Financing


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Burlington Resources is considering three different combinations of short-term and

longterm debt financing:

An aggressive plan consisting of $30 million in short-term debt (STD) and $12 million in long-termdebt (LTD)

A moderate plan consisting of $20 million in short-term debt and $22 million in longterm debt

A conservative plan consisting of $10 million in short-term debt and $32 million in long-term debt

shows the data for each of these alternative proposed financing plans. From the standpoint

of profitability, the aggressive financing plan would yield the highest expected rate of

return to the stockholders13.6 percentwhereas the conservative plan would yield the

lowest rate of return12.9 percent. In contrast, the aggressive plan would involve a

greater degree of risk that the company will be unable to refund its debt because it

assumes $30 million in short-term debt and the conservative plan assumes only $10

million in shortterm debt. This is substantiated further by the fact that the companys net

working capital position and current ratio would be lowest under the aggressive plan and

highest under the conservative planmaking the degree of risk that the company will be

unable to meet financial obligations greater with the aggressive plan. The moderate

financing plan represents a middle-of-the-road approach, and the expected rate of return

and risk level are between the aggressive and the conservative approaches. In summary,

both expected profitability and risk increase as the proportion of short-term debt increases.

Profitability and Risk of Alternative Financing Policies for Burlington


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Optimal Proportions of Short-Term and Long-Term Debt

As is the case with working capital investment policy, no one combination of short- and

longterm debt is necessarily optimal for all firms. In choosing a financing policy that

maximizes shareholder wealth, a firms financial manager must also take into account

various other factors, such as the variability of sales and cash flows, that affect the

valuation of the firm.

A Long and Short Tern Debt

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