What Is Rollover Risk and How Does It Impact Borrowing?

Borrowers who rely on short-term debt often face challenges when refinancing their obligations. If they struggle to secure new funding, they encounter rollover risk—the possibility they won’t be able to replace maturing debt on favorable terms or at all. This can create financial strain for businesses and governments, particularly during economic uncertainty.

Circumstances That Lead to Rollover Risk

Economic downturns make refinancing difficult. When financial markets tighten, lenders become cautious, reducing credit availability. Companies and governments with maturing debt may struggle to secure funding, especially if their financial health is weak. Investors may demand higher interest rates or refuse to extend loans, forcing borrowers to seek alternative, costlier financing.

A weak credit profile increases refinancing difficulties. Entities with high leverage, declining revenues, or poor cash flow may have trouble convincing lenders they can meet future obligations. Credit rating downgrades further limit options. If a corporation’s rating drops from investment grade to junk status, institutional investors like pension funds may be restricted from buying its debt, making refinancing even harder.

Regulatory changes also contribute to rollover risk. Stricter capital requirements for banks, such as those under Basel III, can reduce lending to riskier borrowers. Government policies that restrict foreign investment or impose capital controls may limit access to international funding, complicating efforts to roll over debt in global markets.

Common Debt Instruments

Entities facing rollover risk often rely on short- or medium-term debt to finance operations or expansion. These instruments provide quick access to capital but require periodic refinancing, which can become difficult under unfavorable market conditions.

Commercial Paper

Commercial paper is an unsecured, short-term debt instrument issued by corporations to cover immediate expenses like payroll or inventory. It typically matures in 1 to 270 days and is issued at a discount, meaning investors receive a return when it matures at full value. Because it lacks collateral, only companies with strong credit ratings can issue it at competitive rates.

Reliance on commercial paper exposes firms to liquidity pressures if market conditions deteriorate. During the 2008 financial crisis, many companies struggled to roll over their commercial paper as investors became risk-averse. The Federal Reserve intervened by establishing the Commercial Paper Funding Facility (CPFF) to provide liquidity. If a company cannot refinance its maturing commercial paper, it may have to draw on backup credit lines, which often carry higher interest rates and restrictive covenants.

Corporate Bonds

Corporate bonds are longer-term debt instruments that companies issue to raise capital for expansion, acquisitions, or refinancing. These bonds typically mature in one to several decades and pay periodic interest, known as coupons. Unlike commercial paper, corporate bonds can be secured or unsecured, with secured bonds backed by specific assets.

When a corporate bond matures, the issuing company must either repay the principal or issue new bonds. If market conditions are unfavorable or the company’s financial position has weakened, borrowing costs rise, and finding buyers for new bonds becomes more difficult. If a company issued a bond with a 5% coupon rate five years ago but now faces a market where investors demand 8% due to rising interest rates or credit concerns, refinancing becomes more expensive. This can strain cash flow and reduce profitability, particularly for highly leveraged firms.

Convertible Notes

Convertible notes are hybrid debt instruments that start as loans but can be converted into equity under specific conditions. Startups and high-growth companies frequently use them to raise capital without immediately diluting ownership. These notes have a maturity date, an interest rate, and a conversion feature that allows investors to exchange the debt for company shares at a predetermined price.

Rollover risk arises when investors choose not to convert their debt into equity, requiring the company to repay the principal. If the company’s valuation has declined or market conditions have shifted unfavorably, investors may prefer cash repayment over stock conversion. This can create liquidity challenges, especially for early-stage firms with limited revenue or access to traditional financing. If a company needs to issue new convertible notes to replace maturing ones, it may have to offer higher interest rates or lower conversion prices to attract investors.

Factors That Affect Borrowing Costs

The cost of borrowing depends on market conditions, monetary policy, and lender-specific considerations. Interest rates set by central banks influence the baseline cost of capital. When the Federal Reserve raises the federal funds rate, banks pass on these higher costs to businesses and individuals through increased loan rates. A rate cut has the opposite effect, making borrowing cheaper.

Inflation expectations also impact borrowing costs. Lenders seek to preserve the purchasing power of their returns, so when inflation is projected to rise, they demand higher interest rates. This effect is particularly evident in long-term debt, where persistent inflation can erode the real value of future repayments. Treasury yields, which reflect market sentiment on inflation and economic stability, serve as a benchmark for pricing corporate debt. A spike in yields signals higher borrowing costs across financial markets.

Liquidity conditions in credit markets determine how easily borrowers can access funding. When financial institutions face capital constraints, they may tighten lending standards or charge higher rates. This was evident in early 2023, when regional banks curtailed lending due to deposit outflows and regulatory scrutiny. Companies that relied on bank loans saw their financing costs increase.

Debt structure and repayment terms also shape borrowing expenses. Loans with flexible repayment schedules or interest-only periods often come with higher rates to compensate for added risk. Callable bonds, which allow issuers to repay debt early, tend to carry higher coupons since investors require compensation for the possibility of early redemption. Financial covenants—such as debt-to-equity limits or interest coverage requirements—can also influence borrowing costs. Stricter covenants provide lenders with greater assurance, sometimes leading to lower rates.