Interest Rates & Debt Pricing: Benchmarks, Curves and the All-In Cost

Between July 2022 and September 2023 the ECB raised its deposit rate at ten consecutive meetings, from minus 0.5% to 4%. Three-month EURIBOR, the reference rate on most euro corporate loans, followed. A borrower with €100m of floating-rate debt at a 200 basis point margin went into 2022 paying around €2m a year in interest, because the negative benchmark was floored at zero and only the margin counted, and came out of 2023 paying around €6m. The company had done nothing, their risk profile hadn't changed. The price of money had simply been reset by a committee in Frankfurt whose primary concern is keeping inflation under control.

This article explores the mechanics of debt pricing: what the benchmark is, what sits on top of it, what the curves tell you about where it is going, and, at the end, the calculation of what a floating-rate loan actually costs.

Fixed versus floating

A fixed-rate loan or bond sets the coupon for the life of the instrument. That fixed rate is set at the issuance of the loan or bond, and is (broadly) based on the average expected interest rate over the life of the loan (the forward curve), plus your add-ons for various risks covered in the bank margin. You know your interest bill, it's easy to project cash flows, but you carry the risk that rates fall and you are stuck paying above market rates, and may have to pay prepayment penalties or make-whole clauses if you want to repay or refinance the debt early.

A floating-rate loan resets every one, three or six months to a benchmark plus a fixed margin. You carry the interest rate risk. If rates rise, your interest payments follow; if rates fall, you pay less (to an extent, as rates are often floored at zero).

Banks lend at floating rates because they fund themselves at floating rates. As a result bank debt is almost always priced as floating, with the option to fix as a subsequent decision (either via a hedge, or a fixed-rate loan). Bonds are more often fixed.

So the fixed-floating mix in most debt portfolios is initially driven by the source of funding before any view on rates is taken into account. Interest-rate hedges exist to help manage that exposure (covered in article 3.5.3).

The benchmarks

The floating rate on a loan is a benchmark rate plus a margin. Which benchmark depends on the currency, and the benchmarks themselves have changed materially in the last few years.

• EURIBOR is the euro term rate, published for tenors from one week to twelve months, based on the rate at which panel banks lend to each other unsecured. It survived the reforms that killed LIBOR, was rebuilt on a hybrid methodology anchored in real transactions where they exist, and remains the reference on the great majority of euro corporate loans. It is forward-looking. The three-month rate fixed today tells you what you will pay for the next three months.
• €STR is the euro short-term rate, an overnight rate published by the ECB since October 2019 from actual unsecured overnight bank borrowing. It replaced EONIA, discontinued at the start of 2022. €STR is backward-looking and compounded. You know the interest for a period only at its end. It is the reference for euro swaps and derivatives discounting, but loan markets have stuck with EURIBOR because borrowers like to know their coupon in advance.
• SONIA is the sterling overnight index average, administered by the Bank of England, and since sterling LIBOR ceased at the end of 2021 it has been the reference for essentially all new sterling loans. Sterling loans pay compounded SONIA over the interest period, typically with a five-day lookback so the borrower gets a few days' notice of the amount due. Borrowers who spent decades quoting three-month LIBOR have had to get used to not knowing their interest bill until the period is nearly over.
• SOFR is the secured overnight financing rate, the dollar equivalent, based on overnight Treasury repo and published by the New York Fed since 2018. Unlike sterling (Term SONIA exists but is not as commonly used), the US developed a forward-looking term version, Term SOFR, which is the norm on dollar corporate loans. Because SOFR is a secured rate it carries no bank credit element and sits below where LIBOR would have; the transition added a credit spread adjustment of about 26 basis points to three-month contracts to compensate.
• Base rates are the policy rates: the ECB deposit rate, Bank of England Bank Rate, the Fed funds target (actually a range). Overnight benchmarks track them closely. Term benchmarks or forward curves are built from market bets on where these rates will trade into the future.
• In-house bank floating rates were created by banks when the base rates which their floating exposure used to reference started to diverge from their own funding profile. Overdrafts, retail loans and smaller SME facilities are often priced directly off Bank Rate or an in-house bank base rate, which is simpler for the borrower and gives the bank considerable discretion.

Note: two benchmark features to check in any facility agreement.

The margin and the credit spread

The margin is the lender's compensation for your credit risk, its own funding cost above the benchmark, its capital charge and its profit. In loan markets it is quoted in basis points over the benchmark and is usually the focus of the negotiation. In bond markets the equivalent is the credit spread, quoted over the government curve or over the swap curve, and it is set by investors and arrangers rather than a credit committee.

Both move with two things.

• Your own credit quality, expressed through a rating or a bank's internal grade and often mechanised in a margin ratchet that steps with your leverage ratio.
• The market's general appetite for credit risk, at your level. Investment-grade euro spreads sat around 50-60 basis points in early 2021, roughly doubled during 2022 and drifted back through 2024. A borrower who fixes a margin in a tight market has locked in something valuable; if you are forced to refinance in a wider market, your risk is deemed more expensive, and this is reflected in your rate.

Curves and term structure

We previously explored the cost of debt as building up from a risk-free rate, with margins added for credit, liquidity risk and country risk and other premia.

In reality, it is slightly more complicated. Bonds, loans and swaps are priced off forward rates depending on the term of the loan, and where markets expect rates to trade at various maturities or what they expect to be compensated for holding a certain risk for a certain term. These individual forward rates are plotted to a curve, and these curves are often referred to as the term structure.

They contain a significant amount of information and drive the pricing for borrowers. For a corporate borrower, the key ones are below:

The same job at three sizes