Letter number 99 of December 2016

  • NEW

News : Managing with zero or negative interest rates

In August 2016, one-third of listed bonds worldwide, i.e. $13,700bn, were yielding returns at a rate of less than zero:

Source: Bank of America Merrill Lynch

German government bonds with a 10-year maturity were yielding negative interest (-0.13 %). As for French government bonds, they were yielding a microscopic 0.15%. This phenomenon is not restricted to the Eurozone as we can also see negative interest rates in Switzerland, Japan and Denmark. In other words, in a large number of countries, time no longer means money. 

First, let’s take a look at the why and the how of negative interest rates and then see what the consequences are in terms of the financial management of a firm.

Why are interest rates negative?

Because this is what the European Central Bank wants. And why does it want this? In order to support economic activity, to enable heavily debt-laden EU countries to refinance and to make their debt bearable while they introduce reforms that are continually being postponed, and lastly, to organise transfers (although never referred to a such) between Eurozone countries so as to prevent the Eurozone from exploding.

The first reason is a smoke screen. For many years, academic research has constantly shown that the true determinant of investment is the demand anticipated by companies, and not interest rate levels, which only play a secondary role. If there is little demand, nobody is going to go out and start building factories just because interest rates have been halved. There is evidence of this every day. If lowering interest rates were all that was needed to jump-start the economy, the Eurozone would not have taken eight years to achieve the same GDP in 2016 as its GDP in 2008.

The other two reasons are very valid reasons. Just looking at France, the lower interest rate on its €2,135bn debt has saved it €40bn in interest, i.e. two points of GDP. We’ll leave you to calculate how much Italy has saved, where currently the interest rate is 1.5% compared with over 6% in 2012, on more than €2,200bn in debt. 

Finally, economists believe that a single currency zone can only be viable if transfers are organised to its weaker regions, because, the way the market works naturally is to make the strong stronger and the weak weaker. Would Corsica, the Auvergne and the Corrèze be the flourishing regions that they are today within the French Republic without the net transfers they receive? No, they certainly would not.

Because the European cart has been put before the horse, by creating a single currency without the convergence of economic policies or a budget that is specific to the Eurozone that would enable internal transfers within the zone, the ECB is using interest rates to preserve the euro, doing exactly what Mario Draghi said it would on 26 July 2012: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.” In other words, current interest rates, which are below normal interest rates, are a form of transferring savings achieved by the prudent ants of Northern Europe to the carefree grasshoppers of Southern Europe. We already hear loud complaints from German savers who are no longer earning the interest they expected on their hard-won savings.

But this situation cannot last forever because it has extremely harmful secondary effects (destruction of banks’ profit margins along with their earnings and their ability to increase their own equity capital so as to be able to meet demand for loans which are starting to take off again, with bubbles on some assets that are financed at abnormally low interest rates). So we will have to see the very rapid convergence of the economic, budgetary and fiscal policies of the Eurozone member states, creating solidarity and transfers within the zone because if not, it will explode. And next to that, Brexit will seem like a very minor mishap indeed. 

How can interest rates be negative?

It’s not just about asking lenders to pay interest to borrowers every year, because that would give rise to very complex legal and material problems (especially for listed bonds, held by hundreds even thousands of investors).

In practice, a bond is issued with a nominal value of 100 which earns, for example, 0.2%, but which is sold for 103 and on which 100 only will be repaid at maturity. In Denmark, it’s the amount to be repaid that is reduced, for example to 97 and the issue price corresponds to the nominal value of the debt.

So, with our first example and a 5-year duration, we have a yield-to-maturity of -0.3 % for a nominal coupon of 0.2%.

Over and above inciting the strong investor opinions that its announcements tend to elicit, the ECB uses different methods for achieving its ends. These include lowering its key interest rate (the rate at which banks are able to refinance) to 0%, its deposit rate to -0.4%, buying €80bn worth of assets every month, i.e. the full amount of German issued debt and 45 to 50% of French issued debt including the acquisition of bonds of highly rated companies, and refinancing banks at -0.4% for those that are increasing their loans. And all of this is to continue until March 2017, and even beyond that date.

By buying up securities on the secondary market for very large amounts, the ECB is increasing their price and mechanically reducing their rate of return, even to below 0%.

What are the consequences for the financial management of the company?

Let’s be honest, the idea of a negative interest rate is at the very least surprising and also most unusual for many finance directors and even extremely troubling for some. The very few cases that have been experienced (Switzerland in 1979, Germany and France in the apocalyptical context of the financial markets dislocation in November of 2008) were too fleeting to be able to learn lessons from them.

So, one wouldn’t be surprised to hear an anonymous finance director exclaiming “Today, I get paid by investors to borrow their money but I have to pay to invest my cash on a risk-free basis. It’s the tail wagging the dog!” 

On the assets side

The main danger, we believe, lies in managing the company’s cash.

A treasurer might in fact be tempted to go out in search of the sort of returns that his or her usual money market funds or favourite deposit certificates are no longer bringing in and which may even be costing money. We’ve seen banks offering companies in the Eurozone one-year deposits in sterling earning 1% to 1.2% in dollars (early March 2016). Some treasurers went looking for returns on investments for periods of over a year, from issuers on the periphery (Italian banks, the Spanish or Portuguese governments), even in emerging countries or on the high yield market[1].

They were forgetting that a higher return is only possible at the cost of a higher risk. Our novice treasurer, whether through naivety or greed, who invested cash in sterling deposits so as to earn 1% rather than 0.01% on a euro deposit, would have had a lot of mud on his or her face in late June when as a result of Brexit and the fall in the pound, this investment would have made a 13% loss. All of that trouble just to get, at most, 0.99% more.

It cannot be said often enough, there is no increase in returns without an increase in risk and that when it comes to managing cash, the absolute priorities are liquidity and the preservation of the company’s capital, not to achieve impressive performances on cash investments.

Yes indeed, there are sometimes very good reasons for investing cash at -0.4% (ECB deposit rate) rather than in a money market fund earning 0%. Because 0% is 0.4% more than the risk-free rate and so this means taking a risk that is neither fully known nor generally controlled by the treasurer. 

After all, companies do pay commitment fees on their authorised but undrawn credit lines. Liquidity now has an explicit cost. It would also have a cost if it took the primitive form of keeping banknotes in a safety deposit box (rental, insurance, handling).

In our view, treasurers should not keep their eyes riveted to the figure at the bottom of the assets side of the balance sheet, but should take an aerial view of the whole situation. They will learn that most companies have more debt than investments. In other words, the lack of a return on investments may be regrettable, but it is much less significant than the savings which falling interest rates has enabled the company to record on its financial debts. The company will not be penalised on its income statement by going from cash that brings in, for example 1% and debt that costs 3%, to cash that costs 0.4% and debt that costs 1.6%. The difference between the two is the same. 

A company that has more cash on its books than gross bank and long-term debts will incur a cost. But is it to be pitied? It could always pay out its excess net cash to its shareholders in dividends or share buybacks[2], pay its taxes in advance as we have seen some companies do, even pay its suppliers in advance to secure early payment discounts. In the latter case, the company must ensure that its suppliers don’t get a taste for this, i.e. that they don’t start considering that these short payment periods are what they are entitled to and that they won’t be destabilised on a return to more orthodox practices.

On the liabilities side

There is a second danger, but which to us seems to be less serious, and that is the danger of wanting to take out debt just because interest rates are so low. Yes, they are very low, but there’s no guarantee that they won’t be even lower in a year’s time as has been the case practically every year since 1981[3]. Furthermore, this would be overlooking the fact that if interest rates are low, this is because the economy is sluggish and there are multiple risks. Finally we should remember that whether interest rates are low or not, from a debt service point of view, debt capital repayments are far more often larger than interest repayments. So, on a debt of 100 at 3% over five years, interest rates may well have been reduced three-fold to 1% for example, but the debt service will only fall by 9% and not by two-thirds.

Furthermore, although the cost of borrowing has fallen sharply over the last 3 years (2% for 10-year French treasury bonds), let’s not forget that the cost of capital, which is a tool used to assess the financial relevance of investments, has fallen by a lot less: -0.8% over the same period. Why? Because its second component, the cost of equity is heavily dependent (especially when the risk-free rate is zero[4]) on the stock market risk premium, which itself remains high and has even tended to rise a bit, currently standing at around 7.3%.



Statistics : Recovery rates and length of insolvency proceedings in Europe

Published by the EU, this graphs shows the value of time!

The longer the proceeding, the less important is the recovery rate for lenders: the difference between Romania and Hungary on one side and the UK and Germany on the other is striking.

This is matching the result of a number of research works that shows that the proceedings in pro-lenders countries (e.g. the UK, Germany) are more efficient than the one in countries favouring the survival of the firm. This certainly comes from good intentions but the unemployment rate in France or Italy demonstrates that good intentions are not enough.

Moral: politicians and legislators should listen more to researchers and researchers should act so that their work are spread beyond their closed circle.

Research : Trade receivables and the risk of bankruptcy: what happens at trucking companies

With Simon Gueguen, lecturer researcher at Paris-Dauphine

On 5 January 2006 a reform was introduced in France relating to payment periods in contracts involving a seller in the road haulage sector. Today, 90% of such companies are trucking companies. Concretely, after the reform, the payment period defined in the contract may no longer exceed 30 days. If this is not the case, the trucking company and the customer are both liable to a fine, the maximum amount of which is €75,000. This reform is the result of a parliamentary amendment of a more general law, which was not part of the initial proposal. Accordingly, it was impossible for those affected to anticipate. This is why it has all of the characteristics of a political decision that researchers are keen to exploit, i.e. those of an unanticipated exogenous shock.

The article that we look at this month[1] uses this event to measure the consequences of payment periods on the risk of bankruptcy. The general idea, which is what is behind these changes in the law, is that overly long payment periods penalise SMEs which are subject to liquidity constraints. This is the spirit in which more recently (16 February 2011) a directive was adopted (Directive 2011/7/EU of the European Parliament and Council), limiting inter-company payment periods for all sectors to 60 days (with a few exceptions).

This sort of event provides an opportunity to implement a technique that is frequently relied on in empirical research, the so-called difference-in-difference approach. This involves comparing changes in the parameters of the sample studied (in this case, trucking companies) with changes in the same parameters over the same period for comparable companies (which make up the control group), but which are not subject to the exogenous shock (the new law). This enables us to accurately measure the impact of the law on the sample by distinguishing it from a general change involving all companies which could occur at the same time (without the new law being the trigger thereof). In terms of the article in question, the control group is made up of companies whose position in the value chain is comparable to that of trucking companies but it does not form part of this sector.

Firstly, Barrot shows that this reform shortens effective payment periods in the sector (by 15%). Average trade receivables dropped from 19% of sales to 16% of sales between early 2006 (introduction of the reform) and late 2007. He then looks at the way that trucking companies’ risk of defaulting changes. This is the most interesting result of the study: their risk of defaulting falls by 60 base points, i.e. one quarter of their risk level before the reform. This effect is particularly noticeable for small, newly set up, highly indebted companies and those that pay out small dividends. In other words, companies which are more likely to experience financial constraints. No such trends were identified before the reform which means that this is not a general trend but that the new legislation seems to be behind it. Additionally, the fact that this law was introduced over 10 years ago means that Barrot was able to verify whether the effect persists over the following years (the risk of defaulting does not increase again).

It might be assumed that the weakest companies make up for the long payment periods that their customers impose on them by charging higher prices in order to cover their liquidity risk. This is not confirmed by the results of this study. The fall in trade receivables after the reform has not been followed by a fall in prices. Finally, Barrot draws attention to the increase in the number of new entrants in the haulage sector after the reform.

Overall, this study shows that a shortening of payment periods (imposed by law) seems to encourage the entrance and the survival of small companies that are subject to financial constraints. This corresponds to the goals that lawmakers were seeking to achieve (in terms of both domestic and European law). However, as Barrot rightly states, this result is insufficient to prove that such reforms are positive for the economy as a whole. By reducing contractual possibilities, they impact on all companies. So the central question remains open: in the absence of restrictive legislation, is the average amount of trade receivables excessive?

[1] J.N. Barrot (2016), Trade credit and industry dynamics: evidence from trucking firms, Journal of Finance, vol. 71-5, pages 1975-2016.

Q&A : Q&A posted on Facebook

Here are some questions sent in by readers with our answers that are now posted daily on the Vernimmen Facebook page[1].

Computation of the beta: Over which period? Which index? As an average or as a weighted average of peer’s betas?

Take a period of 3 years, which is long enough to collect sufficient data and short enough for the company not to have significantly changed its structure in the interval. You will find on the vernimmen.com website a spreadsheet that will help you to make the computations.

Weekly or even daily prices are more appropriate because they provide more statistical data and enable you to follow market fluctuations more closely.

You must take the main index of the market where the highest exchange volumes on your share take place. As most of the time a smaller index of large groups represents a significant part of a broader index, whether you take one or the other does not fundamentally change things, but if you can, it is better to take the broadest index.


In general it is an average, not a weighted average, I have not seen weighted average calculations as far as I can remember.

In the case of a tender offer on its own shares, is the redemption price offered by the company equal to the share price?

Generally in the case of an tender offer of a listed company on its own shares (the "offer"), the redemption price is set at 10-15% above the recent share price to prevent, during the 15 days to 3 weeks that an offer lasts, and if the stock market increases, the share price from jumping above the offer price which would lead to the failure of the offer.

There is no arbitrage possible as a company never buys 100% of its shares but 1 out of 10 or one out of 5, for example. So if I buy 5 shares on the market during the offer and pay the stock market price, there is only one that I am sure to be able to sell at the price of the offer. The others will not be redeemed. They will be worth what they are worth after the offer. It is this uncertainty that makes arbitrage impossible.

Especially since a share buyback does not create value in itself. The fact that a company pays a premium of 15% for example for one share out of 5 destroys value for the 4 other unredeemed shares whose value post offer should decrease by 15%/4.[2]

[2] For more, see chapter 37 of the Vernimmen.


New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.

Last week, BNP Paribas announced an inaugural issue of green bonds for an amount of €500m. The transaction triggered a strong demand from investors that allowed it to set a lower interest rate than the benchmark curve for the classic senior debt issues of BNP Paribas.

This would be the first time, to our knowledge, that investors have accepted a lower interest rate on a green bond than on a conventional bond. If this were to be confirmed by other observations, two points could be inferred:

1 / investors really want to help the planet meet COP21 objectives,

2 / issuers could thus finance themselves structurally using green bonds at no extra cost compared to a conventional bond as is presently the case. Indeed, with the same interest rate, a green bond costs more than a conventional bond because of the extra cost involved in controlling the use of funds in green projects.


A dynamic of even faster growth of the share of green bonds would then be engaged. For those of you who have forgotten what green bonds are, read the January 2015 issue of the Vernimmen.com Newsletter.

As a reminder, green bonds are issued, except for supranational issuers (such as the World Bank), first by French groups (16% of issues), German (12%), Dutch (11%), American (8%) and Chinese (4%).


Facebook implements advice given in the Vernimmen

To thank us for joining Facebook.com, Facebook Inc. announced on Friday that it wants to repurchase up to $6bn of its own shares, which we recommend doing (in Chapter 36) from any company that is at ease with its financial structure and that is no longer able to find investment projects which can be expected to earn at least their cost of capital. In this case, it is better to return the cash to shareholders, for them to find investment opportunities elsewhere which the company is no longer able to find (trees do not climb to heaven indefinitely).

With $26bn in cash on the balance sheet for a market capitalization of $340bn and $6.5bn of free cash flow over the first nine months of 2016, Facebook most certainly does not need to raise cash! This $6bn will no longer be invested in risk-free assets such as Facebook's cash, but probably in companies that need equity but are unable to generate enough by themselves, the position Facebook was in a few years ago. It is good thing for money to circulate, and it is a natural and healthy cycle, although in the case of Facebook, it happened particularly quickly, but, as they say, when the winner takes all. . .


Sharp rise in long-term interest rates (+ 0.5% in a few days), a small rise in risk premia (as shown by the rise in credit spreads) and a rise in equity markets. I seem to be forgetting what I learnt in my Vernimmen. Would investors have revised their forecasts of future results upwards (in this context of increasing protectionism)??


Snap, previously known as Snapchat, prepares for its IPO due in early 2017.

For this purpose, preferred shares carrying 10 voting rights each will be created alongside ordinary shares with one voting right. This means that the two co-founders, Evan Spiegel and Bobby Murphy will not be significantly diluted, even if they apparently own 74% of the company. This is not a recent innovation in the USA since it was used in the past by the Ford family well before Murdoch, Google, Facebook or LinkedIn. But it is not a general rule either as Amazon, Apple and Twitter have not used it. In France, Germany, Italy, Spain and Belgium multi-voting right shares are prohibited. Instead, we have limited partnerships such as Hermes, Michelin, Henkel or Merck that allow a family to keep control over a company. More details in chapter 41 of the Vernimmen that focuses on shareholders and the choice of a corporate structure.https://www.facebook.com/Vernimmencom-682493761918930/


[1] Like it here