A regulatory decision April 26 deems the TNC a charter-party carrier, subject to stronger safety, insurance, and licensing.
Thirty years ago, fixed-rate fleet leases were the norm. "X over/under Prime" was the standard proposal when fleet lessors presented their proposals to the fleet manager.
Then, however, things began to change. Lessors started offering rates that floated, i.e., changed as the underlying debt changed. Loans based on the Prime rate (floating rate money, contrary to what is often believed) were joined by:
■ LIBOR funds: LIBOR is an acronym for London Interbank Offered Rate. These are funds loaned between banks for short-term needs.
■ Commercial paper: These short-term debt instruments are bought and sold between companies, and are also used to fund short-term needs.
■ Treasury issues: This is debt sold by the federal government.
Fleet managers found themselves nearly overwhelmed by the menu of funding possibilities.
The question became one of the fleet industry's fundamental questions: fixed or floating, or even both?
Reviewing Fleet Lease Basics
The open-end terminal rental adjustment clause (TRAC) lease is unique to the fleet leasing industry. There are open-end leases, and there are TRAC leases for other categories of leased assets. However, a combination of the two is the most common method used by companies that lease fleet vehicles.
The fleet lease contains several basic terms and conditions:
■ The lease payments consist of a reserve for depreciation, an interest charge, and an administrative fee.
■ The lease has a short (usually 12-month) minimum term, after which the lessee can terminate the vehicle lease at any time.
■ Vehicles are amortized in a straight line. When replacement is anticipated, the unamortized balance represents the vehicle's fair market value on the open market.
■ When vehicles are sold, the proceeds are applied to that balance. If the proceeds are greater, the lessee receives the excess. If they are lower, the lessee must make up the difference.
The flexibility of the typical fleet lease is its greatest benefit. Vehicles have different missions, drive in different geography, and accumulate mileage at different paces. Fleet managers must be able to replace vehicles at different points in their lifecycles. The open-end TRAC lease enables this flexibility.
How Fleets are Funded
The unique nature of a fleet lease presents the lessor a challenge: how to recover the investment (and corresponding debt) in vehicles purchased for the lessee? Traditionally, an interest charge is assessed. This charge is not based upon the actual outstanding balance, which, because of the straight line depreciation reserve, is different every month and results in differing payment amounts. Rather, the interest charge is calculated on the average outstanding balance, taken in annual increments.
The difference is that the floating rate lease payments change as the rate on the underlying funding changes; the rates charged in the lease usually float monthly. When a new vehicle is placed in service, the lessor generally produces a Schedule A, a document detailing the vehicle's capitalized cost, and lease payment schedule. The scheduled monthly lease payments decline each year, due to lease payments based upon the average annual outstanding balance. When the rate floats, the payment changes. (A new Schedule A is not produced, for obvious reasons.) In a fixed-rate lease, the payments remain as they are first shown on the Schedule A.
One of the most common debt instruments used in the fleet leasing industry, LIBOR is the rate charged by member banks for one-month, three-month, six-month, and one-year loans made between each other. LIBOR rates are fixed each day at 11 a.m. Considered short-term loans, they are made between banks that have liquidity needs and those with excess cash.
LIBOR was one of the first non-Prime-rate floating funding sources in the fleet industry and historically has been lower than the Prime lending rate. (Short-term funds usually are lower.) As the banking industry battles the current credit meltdown, LIBOR rates have plummeted; 30-day LIBOR rates as of Feb. 4, 2009 were 0.45 percent versus as much as 4.29 percent in October 2008. January's one-year LIBOR was just slightly over 2 percent. With Prime at 3.25 percent, LIBOR funds would be a very attractive funding source; however, they are very scarce (one reason why the rates are so low) as credit overall has dried up.
Commercial Paper for Short-Term
Debt known as commercial paper are funds financially strong companies issue to one another. Commercial paper is used for short-term funding needs, such as inventory and payroll. (The SEC requires commercial paper be available only for "transactional purposes," not for general borrowing.)
Commercial paper is sold for needs in the 30- to 45-day range, though regulations allow it to mature at up to 270 days. Buyers depend either on the financial strength of the borrower or the value of the assets underlying the debt. (Some commercial paper is secured with consumer loans, mortgages, etc.) Asset value has caused the credit squeeze in the commercial paper market. Trillions of dollars of bonds and commercial paper issued by mortgagers, banks, and other moneylenders were backed by mortgage loans. When the home values underlying these securities plummeted, much of the paper became worthless.
Fleets also use commercial paper to fund floating-rate leases and have been squeezed by the scarcity of these funds.
U.S. Treasury Sells Debt Instruments
From time to time, the U.S. government requires money to fund its activities, if revenues from economic activity (taxes, tariffs, and fees) are not enough. The Treasury Department sells three primary debt instruments to raise such funds:
■ T-Bills. These short-term funds (with maturity of one year or less) are sold on a "discounted" basis. Unlike Treasury Notes and Bonds which pay interest, T-Bills are purchased at a discount of their face value. If, for example, a T-Bill value is $10,000 and the return is pegged at 3 percent, the purchaser paid $9,700, a 3-percent ($300) discount. T-Bills are sold at maturities ranging from one month to one year.
■ T-Notes. Longer term debt, T-Notes range from one up to 10 years in maturity. T-Notes pay interest to the purchaser semiannually and are redeemed at face value at maturity.
■ T-Bonds. The longest term debt instruments the Treasury issues, T-Bonds maturities range from 10 to 40 years. Like Notes, T-Bonds pay interest twice a year and are redeemed at maturity at face value. One exception: some 30-year T-Bills can be redeemed after 25 years.
The single biggest difference between Treasury issues and other forms of commercial debt is safety. All Treasury debt instruments are backed by the "full faith and credit" of the U.S. government. There is, however, an open market for the sale of Treasuries, and their return can vary accordingly for buyers and sellers.
The attraction of Treasuries for fleet lessors and lessees is the wide range of maturities. With short-term T-Bills at one month, very long-term Bonds at 30 years, and other funds nearly everywhere in between, they are well suited for funding both fixed and floating rate leases.
Prime Rate Adjusts to Fed Rates
The Prime lending rate is the rate at which banks lend to their most credit-worthy customers. Banks usually correlate Prime rate adjustments to changes in the Fed Funds rate (the rate set by the Federal Reserve at which member banks lend to each other overnight). The prime rate is the most widely used interest rate for various consumer and commercial loans, mortgages, and other longer-term debt. As previously mentioned, most fleet leases before the late 1970s were funded by debt linked to the prime rate, until shorter-term, floating rates began to be used.
Prime is a floating rate. It changes based upon actions by the Fed and member banks. Prime rate, however, is more often used for fixed-rate loans, as it does not move as frequently as do shorter-term debt instruments such as LIBOR or commercial paper. Indeed, prime rate has been used as a floating rate indicator, though not as often today as in the past. Prime rate debt is the most common fixed-rate fleet lease.
Fixed or Floating?
In the past, a fleet's decision to choose a fixed or a floating rate lease depended upon one overarching factor: which way did the company believe rates were headed? Borrowers in the mid- to late 1970s, with enough foresight and knowledge of the credit markets, were smart to choose fixed rate funding since interest rates skyrocketed in the period from 1977 to 1982, peaking at more than 20 percent. (Actually, few floating rate leases were available at that time anyway). Since then, the Prime rate has ratcheted downwards and today stands at 3.25 percent.
After the "stagflation" of the late 1970s and early 1980s, when the Fed labored to squeeze rampant inflation by raising rates, inflation has not been a significant factor in the economy. The double-digit inflation of the 1970s and early 1980s, as high as 13-plus percent, since has ranged as low as slightly more than 1 percent.
The combination of low inflation, low interest rates, and the introduction of new, shorter-term debt into the fleet leasing industry has made floating rate leasing the means of choice for most mid- and large-market fleets, and for good reason. Despite the occasional spike (e.g., from June 2004 to July 2006, the Prime rate more than doubled from 4 to 8.25 percent), the long-term trend in interest rates has been down.
Another feature of many floating rate fleet lease agreements is the option to switch to fixed rates at any time. This option is nearly always limited, only once in the life of the lease. However, if interest rates begin to trend upwards, it is one way to mitigate interest costs.
Currently, we are entering uncharted financial waters. The unprecedented meltdown in the credit markets has brought on the previously unseen problem of very low interest rates with frozen credit markets. While short-term, floating rate debt is at historical lows, (actually hitting zero percent at one point), there is simply little such money to be had, as banks (LIBOR) and companies (commercial paper) are neither lending nor borrowing.
These circumstances have led some fleet lessors to tell customers they cannot accept new-vehicle orders under the terms of existing contracts. Little or no money is available to fund the orders. The economic picture going forward is a cloudy one; no one really knows how this will all pan out in the end and how long it will take. Exercising the fixed rate option now might be a good idea.
Fixed and floating rate options each offer benefits. Fixed rate fleet leases allow more precise budgeting - pinpointing payment amounts for the life of a vehicle. In an environment of rising interest rates, "opportunity savings" are available as well.
The primary benefit of floating rates is that the debt instruments used to fund them are lower than most longer-term debt funding fixed rate leases. Risk occurs, however, when vehicles are brought into service under a floating rate lease, and rates rise. The lease costs more than it would have if the lease rate was fixed.
Thus, deciding between a fixed or floating rate lease is a little like choosing a ballplayer for a fantasy baseball league. Past performance matters, but a bad season or a hot streak can make the decision look bad, or good, in retrospect.
It is important fleet managers understand not only the difference between the two lease options, but the various debt funding forms and to research the history of each before making a decision. Keeping in close touch with the company treasurer will go a long way toward making a good choice, and an agreement that permits movement from floating to fixed (the reverse is usually not an option) can help mitigate the effect of rising rates.
Note: This article appeared in the March/April 2009 issue of Fleet Financials, a Bobit Business Media publication.
A regulatory decision April 26 deems the TNC a charter-party carrier, subject to stronger safety, insurance, and licensing.
2018 ILCT Show Digital Exclusive: This session packed a wallop with advice on how to be a better sales professional.
2018 ILCT Show Digital Exclusive: Experienced operators share the best events to pursue when looking for more retail revenue.
2018 ILCT Show Digital Exclusive: A peer-to-peer roundtable looks at the best tools for expanding your operations.
TNC drivers rely on navigation all the time. A good chauffeur will combine it with solid local knowledge.
Sam Mallikarjunan of HubSpot can help you prepare your business for inevitable future shake ups.
If you're looking for ways to cut costs and boost safety, be sure to register for this LCT webinar.
The driver browsed videos on his smartphone while headling down a New York highway with 52 passengers.
Companies can reduce their vehicle collisions up to 35% by improving how they manage driver risks.
APRIL LCT: The platforms can be a great tool for connecting but can also explode over posts that were not thought out.
Instead of seeing AI as a replacement for human endeavors, try to see it as an enhancement of them.
APRIL LCT: CTA Worldwide Chauffeured Transportation succeeds by meeting the growing demand for group transportation.
The passenger pounded on windows after the driver pulled off the highway, locked the doors, and said they were going to a hotel.
The Bill Faeth-hosted event answered some burning questions for operators.
eNews Exclusive: Kevin Polite has joined forces with veteran operator Robert Alexander to provide Washington, D.C. area clients with #RMAperfect rides.
The world's No. 1 online marketplace and trader for professional chauffeured and chartered vehicles, including all types of motorcoaches, buses, vans, stretch limousines, sedans, SUVs, exotics, and classics. New and used vehicles are available from sellers across the nation.
The best online networker to find quality affiliates worldwide and market your company.
Click on any state to see the latest industry news and events in that region.