There are a number of fleet strategies that fleet managers must examine regularly in order to maintain the highest level of cost efficiency. Do we lease, or do we own our fleet vehicles? Outsource or retain in house management?

One of these key strategies is deciding whether the fleet should be funded via fixed or floating rate funding. This strategy is required whether the company is leased or owned. One way or another, vehicles must be funded.

In recent years, funding rates have been at historical lows for quite some time. Interest rates hovered around 1% or 2%, and have held steady; most fleets fund using a floating rate source. Is it time to reassess? Should fleet managers begin to fix existing floating rate funding, and do so going forward with new vehicle orders? Let’s take a look.

Funding Options

In the early days of the fleet management profession, the sort of funding options for leased vehicles we see today didn’t exist. Fixed term, closed-end leases offered only a term, a payment, and a residual value. Even with the onset of the open-end TRAC (terminal rental adjustment clause) lease, the funding portion of the lease rate factor was nearly always fixed, and based on the Prime lending rate established by the Federal Reserve (old timers in the industry will certainly remember “prime plus one” or “prime minus one” in lease proposals).

This began to change in the late ’70s and early ’80s, as fleet lessors began to offer the alternative of floating rate funding, initially using the prime lending rate as the basis, but eventually offering other options to fleet managers. Today, most fleet lessors offer a market basket of funding options. Here are some of them:

Prime Rate: Yes, some lessors still offer both fixed and floating rate funding for fleet leases based on the Prime lending rate.

LIBOR: London Interbank Offering Rate. LIBOR is essentially the rate at which the world’s leading banks charge each other for short-term loans. Maturity on LIBOR funds range from overnight to 12 months; thus, LIBOR is almost always used for floating rate funding.

U.S. Treasury issues: The U.S. Treasury sells bonds, notes, and bills at auction. Treasury issues are considered among the safest investments available, as they are backed by the full faith and credit of the U.S. government. T-bills mature in less than 12 months, notes offered in terms from 2 to 10 years, and Bonds for 30 years. Issues are auctioned daily, so the rates available vary with demand; this makes these issues a popular option for floating rate funding.

Commercial Paper: Commercial paper are funds issued by corporations for short-term funding needs. Blue chip companies can issue commercial paper that is backed only by their own creditworthiness; other companies will back the loans with assets. Major fleet lessors often issue their own commercial paper to fund leases.

Securitization: Similar to commercial paper, fleet lessors will sometimes bundle leases into a security and sell the payment streams as an investment. Securitization received somewhat of a black eye during the financial shock of 2008, as mortgage companies secured investments with mortgages which were, in many cases, issued to very weak credits, and whose underlying property was “upside down;” the mortgage was greater than the value of the property, rendering such securities worthless.

These are among the many options available to fleets, and not just for leasing, either. There are a number of options available to fund purchases for company-owned fleets as well.

Research Funding History

Like any investment, funding fleet vehicles begins with researching the history of various options. Such history, after the financial meltdown of 2008 up until the end of 2015 and early 2016 is fairly steady for most of the funding options listed above; indeed, for some short-term funds, the rates actually hovered just above 0%. However, in early 2016 most short-term rates (1 year or less) began to creep higher. At the time of this writing, Treasuries and LIBOR are in the 1% area, give or take a few basis points (a basis point is equal to 1/100th of a percent; i.e., 25 basis points is .25%).

Previous history has shown far different rates. In the infamous “stagflation” days of the mid ’70s into the early ’80s, interest rates skyrocketed; the Fed in an effort to choke off inflation sent the Prime lending rate to as high as 21.5% by the end of 1980.

What this all means is that sometimes, it’s pretty much a roll of the dice trying to anticipate interest rates, particularly short-term rates, which are most popular in funding fleet leases. Rates are not always just a function of supply and demand; politics unfortunately play a major role in what lenders charge borrowers for their money.

Buying Vehicles

Tracking, as we previously noted, interest rates and choosing either fixed or floating funding isn’t just a decision required of fleets that lease; it also plays a part when company owned fleets buy. These fleets have a few funding options available to them when they buy vehicles.

Cash from operations: Cash generated in the course of doing business is one option; its cost, however, known as an “opportunity cost,” is equal to the company’s net after tax profit margin. If that margin, for example, is 5%, when the company uses its own cash for vehicles, it is forgoing on the opportunity to re-invest that cash internally, from which they can expect a 5% return.

Bank credit lines: Most companies have banking relationships, which often include revolving lines of credit. These lines can carry rates as high as prime plus 9% (short term, small lines) and as low as 1.75% over prime (for small to mid-sized companies). Larger lines, for example those in a large corporation, naturally carry lower rates. These lines, however, are usually used for short-term cash needs; when the company runs out of money before they run out of month, they can dip into these credit facilities to make payroll, pay suppliers, or finance inventory.

OEM credit business units: All of the auto manufacturers have finance/leasing business units, who offer commercial lines of credit to finance the purchase of their products (and sometimes, other OEM’s products albeit at higher rates).

Related: Eliminating Hidden and Soft Fleet Costs

These and other options provide company owned fleets with the ability to purchase vehicles outright. Are these funding sources fixed, floating, or do they offer both? Using cash from operations is essentially a fixed rate option; the opportunity cost of the funds is fixed at the time the purchase is made at the net after tax margin extant at that time.

Revolving credit lines can be either fixed or floating; however, they are generally used for more pressing, immediate needs as described above, rather than for vehicle purchases that can generally be delayed. The OEM credit facilities are a great way for small- to mid-sized companies to fund vehicle purchases. Most of them are fixed rate lines, however a fleet may be able to negotiate a floating rate line.

Leasing

Most larger companies, with bigger fleets, choose to conserve capital and lease their vehicles, usually from a national fleet management company, via an open-end TRAC lease. Such leases provide both the cash flow benefit of leasing, as well as the equity benefit (or risk) of ownership.

TRAC leases consist of three primary elements:

• • Reserve for depreciation.

• • Funding.

• • Lease fees.

It is the second element, funding, which provides fleet lessees with a number of options. Most lessors offer a range of funding sources, some of which (LIBOR, commercial paper, securitization) we’ve discussed previously. The question is both which source to use, and should the company choose fixed or floating funding in their fleet leases.

As we’ve also seen previously, trying to anticipate interest rate movements can be a tricky affair; choosing wrong (imagine if you chose fixed rate funding at the peak of the inflationary period in the early ’80s) can cost a company millions. Fortunately for fleets, lessors have worked diligently to structure lease agreements that offer not only funding options, but the opportunity to move existing leased vehicles from one to the other (fixed to floating, or the reverse). This helps fleets choose the manner of funding their leases, and allows them to correct themselves if they chose badly.

Considerations for Fixed and Floating Rates

Clearly there are a number of options available to fleets in either purchasing or leasing their fleet vehicles. But knowing what options you may have is a far cry from determining what option to use. There are benefits and drawbacks to both options (fixed or floating) that fleet managers should consider when making this key decision.

We can start out by examining the rates the various options offer. First of all, as with any investment, the shorter the term, the lower the cost (or in the case of an investment, the return). Thus, a rate based upon a 30-day Treasury issue will be lower than one on 90-day commercial paper or a one-year Treasury. Shorter term funds are always cheaper than long-term funds. Short-term funds, however, are more volatile, so floating rates can be painful in the event of a political or economic shock, or even a period of uncertainty. It is also a matter of risk. When a lender lends for a short period of time, risk is minimized; the longer the term, the greater the risk, and thus the higher the cost.

Related: Balancing Cost Reduction with Productivity Gains

Keep one thing in mind; the funding source chosen by a fleet lessee is the basis for the rate; it is not necessarily the source of funds the lessor uses to fund the transaction(s). For example, if the customer chooses 90-day Treasury bills as the rate basis, the lessor isn’t necessarily using Treasury bills as actual funding; they are using the rate those issues are returning as the basis for the rate in the lease (there will nearly always be some markup on whatever source the rate is based upon, i.e., 90-day Treasury bills plus 25 basis points). This goes for whatever basis is chosen by the fleet for funding.

So, choosing a rate basis is part of the decision making process. Short-term rate indicators are cheaper options than longer term options, but are more volatile.

Corporate treasurers work diligently to track company debt, including lease obligations. A critical part of this work involves tracking the movement of all of the funding rates we’ve covered here, with the goal of finding trends in interest rates.

Common sense will tell you that in an environment of rising interest rates, it is smart to at the very least offset some of a company’s floating rate financial obligations with fixed rate funds. For example, back in those painful late ’70s and early ’80s, any company that foresaw soaring interest rates and was able to fix debt saved millions or more. The same goes for diligent treasurers after the financial meltdown of 2008; rates plunged, and those who funded with floating rate debt (including leases) won the financial day for years afterward. Looking at charts showing interest rate movements in the last 18 months can clearly see that rates, though still at historic lows, have begun to creep upward. With the economic picture in the short- and medium-term strengthening (increasing demand for capital and thus increasing rates), treasurers are looking to fix some of their floating rate debt.

So, it doesn’t take a financial PHD to see that in an environment of rising rates, fixed funding for fleet vehicles (whether purchased or leased) is usually a major consideration. And contrarily, if the economic picture points to steady, or falling, rates a fleet is likely to go for shorter term, cheaper funding and floating obligations.

All of this said, it is seldom a good idea to put all one’s funding eggs in one basket. Much like it’s a good idea to offer a selection of vehicles whenever possible, it’s also smart to use both fixed and floating options when purchasing or leasing vehicles. When rates are rising, fixing lease rates on a majority of new orders is smart; its even smarter to hedge those fixed orders with some floating rates as well. The reverse is, of course, true in an environment where rates are steady or falling.

Talk to the Treasurer

It is most important to develop a relationship, and engage in regular communications with, your treasurer. It is likely that he or she has little idea what the structure of your lease transactions are, but surely knows what the rate trends are, and can provide great input and advice as you determine how to fund fleet units.

Make sure treasury knows what funding options are available, that purchases or leases can be funded with either fixed or floating rages, and most importantly that in many cases existing vehicles that are either fixed or floating can usually be reversed (fixed changed to floating and vice versa) one time during the lease term.The input from treasury is invaluable in both choosing funding rate bases, as well as whether to fix or float those rates.

Related: Identifying the Right Funding Options for Your Fleet