Frequently Asked Questions: FinListics Newsletter March Edition

What's an Interest Rate Spread?

by Guillermo Bustamante, Director of Research at FinListics Solutions

Q: What’s an Interest Rate Spread?

A: You’ve probably heard on the news or from your client that it’s more costly to borrow money in the current environment. But what exactly does this mean and why is this important to you? Let’s answer the second part of this question first.

The more a client pays in interest means they have less money to invest back into the business and fund initiatives—like, perhaps, yours! Here’s a real example: Limited Brands, well known for its Victoria’s Secret brand, refinanced a $750 million loan in 2008. Because of higher interest rates, it will pay a whopping $20+ million in interest for the same loan!

The interest rate a company pays is determined by two factors:

• The base rate like LIBOR (London Inter-Bank Offer Rate) or Prime Rate
• The spread an individual company pays on top of the base rate

The base rate is primarily determined by a number of macroeconomic factors like the stage of the business cycle. Typically, when economies slow down, the base rate is low due to the lack of demand for loans. Likewise, in periods of economic expansion, the base rate rises because of the increased demand for funds.

The spread reflects an individual company’s credit risk—the likelihood it will pay back the loan. More credit-worthy companies pay a lower spread than the less credit-worthy ones. In the current economic environment, the spread for most companies has reached historical highs as banks have few funds to lend. In the case of Limited Brands, the spread on the $750 million loan skyrocketed to 350 basis points (3.50%) from only 80 basis points (0.8%). So if LIBOR is at 2.00%, the Limited Brand’s interest rate is 5.50%, compared to 2.80%.

You won’t likely be able to lower a client’s interest rate, but you can help by considering these important questions: What solutions do you provide to lower the amount of funds a client needs to borrow, like solutions that help them better manage working capital and fixed assets? And what solutions do you offer that lower other expenses like Cost of Goods Sold and SG&A that will help offset the higher cost of borrowing? Your answers will help determine the likelihood of your success in helping your clients keep costs in check.