The overlap cost of refinancing early, worked through, and the rise in yield it insures against.
Negative carry is the new bond's coupon minus what the proceeds earn on deposit, for the months the cash sits idle. Pre-funding a 500 million maturity nine months early with a 5.40 per cent bond, while the cash earns 3.90 per cent, costs 5.625 million before tax, or 4.22 million after 25 per cent tax. That is the premium for removing refinancing risk, and it breaks even if the new-issue yield would have risen by about 26.3 basis points by the maturity date.
Worked in full in Treasury Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A bond maturity is the one cash outflow a company can see years ahead and still be caught by. If markets are shut in the month the bond falls due, the company refinances at whatever price is available, or draws its revolver, or does not refinance. Pre-funding moves the new issue to a window the treasurer chooses and parks the proceeds until the old bond is repaid. Rating agencies and lenders tend to look favourably on maturities that are covered well in advance, and the treasurer sleeps better. None of that is free. For the months the company carries both bonds it pays interest on money it is holding as cash, and the deposit earns less than the debt costs.
| Input | Value |
|---|---|
| Maturing bond, refinanced in full | 500 |
| Coupon on the maturing bond | 3.25% |
| Yield on the new 5-year bond, issued today | 5.40% |
| Rate earned on the proceeds until maturity | 3.90% |
| Pre-funding period | 9 months |
| Tax rate | 25% |
Step 1: what the new bond costs during the overlap. Nine months is 0.75 of a year. Interest on 500 million at 5.40 per cent for 0.75 years is 20.250 million.
Step 2: what the cash earns. The same 500 million on deposit at 3.90 per cent for 0.75 years earns 14.625 million.
Step 3: the carry. The difference is 5.625 million, or 0.625 million for each month of pre-funding.
Negative carry = amount × (new yield − deposit rate) × months ÷ 12
500 × (5.40% − 3.90%) × 9 ÷ 12 = 500 × 1.50% × 0.75 = 5.625
After tax: 5.625 × (1 − 25%) = 4.22, on the assumption that the interest is deductible and the deposit income taxable at the same rate.
In Excel: =B1*(B2-B3)*B4/12*(1-B5)
The maturing bond's 3.25 per cent coupon plays no part. It is paid whether the company pre-funds or not, so it is not a cost of the decision.
The carry is the price of an insurance policy against the new-issue yield rising before the maturity date. To read it as a break-even, convert it into a rise in yield on the new bond. Each basis point on a 500 million, 5-year bond at 5.40 per cent costs 500 × 0.01% × 4.2820 (the annuity factor) = 0.2141 million in present value.
Break-even rise = carry ÷ (amount × annuity factor) = 5.625 ÷ (500 × 4.2820) = 0.26%, or 26.3 basis points
If the treasurer believes the company's all-in new-issue yield could plausibly be more than 26.3 basis points higher in nine months, through rates, its own credit spread or a closed market, the pre-funding is cheap. A 50 basis point rise would have cost 10.71 million in present value, so pre-funding comes out 5.08 million ahead. A 25 basis point rise costs 5.35 million, and pre-funding is 0.27 million behind. A 100 basis point rise, or a closed market, makes the 5.625 million look trivial.
| Months early | Carry at 1.00 pt | Carry at 1.50 pts | Carry at 2.00 pts | Break-even at 1.50 pts |
|---|---|---|---|---|
| 3 | 1.250 | 1.875 | 2.500 | 8.8 bp |
| 6 | 2.500 | 3.750 | 5.000 | 17.5 bp |
| 9 | 3.750 | 5.625 | 7.500 | 26.3 bp |
| 12 | 5.000 | 7.500 | 10.000 | 35.0 bp |
The cost is linear in months and in spread, so twelve months at a 2.00 point gap costs 10.000 million and needs a 46.7 basis point rise to break even. Two things narrow the gap: a better deposit rate, which usually means accepting more counterparty or duration risk on the cash, and a shorter window. Pre-funding three months early at a 1.50 point gap costs 1.875 million and breaks even at 8.8 basis points, which many treasurers would accept as cheap insurance.
Counting the full new coupon as the cost. The 20.250 million of interest in the overlap is not the price of pre-funding; the 14.625 million earned on the cash comes back, and the real figure is 5.625 million. The opposite mistake is to compare the new yield with the old coupon, a 2.15 point gap, which mixes a refinancing decision the company has to make anyway with the timing decision it is actually taking.
Pre-funding leaves net debt unchanged but raises gross debt for the overlap. With 1,000 million of net debt and 400 million of EBITDA, net leverage stays at 2.50 times, while gross debt rises by 1.25 turns of EBITDA until the old bond is repaid. Check any covenant or ratio defined on gross debt, and check whether your facility counts all of the cash.
Compute the carry as amount × (new yield − deposit rate) × time, convert it into a break-even rise in yield, and decide whether that rise is more or less likely than not. On these figures, 5.625 million buys protection against any move above 26.3 basis points. The free workbook for the book's case prices the different ways of holding liquidity side by side, and for where to put the proceeds while they wait, see where a company should park its surplus cash. For the broader question of how much cash to hold, see how to set a minimum cash balance.
There is no fixed rule; it is a trade-off between carry and refinancing risk. Each month of pre-funding 500 million at a 1.50 point gap between bond yield and deposit rate costs 0.625 million. Three months costs 1.875 million and breaks even at an 8.8 basis point rise in yield; twelve months costs 7.500 million and needs 35.0 basis points.
Usually the interest on the new bond is deductible and the deposit interest is taxable, so the carry is reduced by the tax rate, subject to interest limitation rules. At 25 per cent tax, 5.625 million of pre-tax carry becomes 4.22 million after tax. Check local rules before relying on the after-tax figure.
Net debt is unchanged because the new debt is matched by cash, but gross debt rises for the overlap. With 400 million of EBITDA, a 500 million pre-funding adds 1.25 turns of gross leverage while net leverage stays at 2.50 times, which matters for covenants and ratios defined on gross debt.
This article is one calculation from Treasury Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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