I’m going to start today by telling you something very obvious: the new hot trend in contracts this offseason is extremely long deals. You know it. I know it. Ken Rosenthal says it, so it must be true. Living legend Jayson Stark laid it out as only he can: we’ve seen three free-agent deals of 11 or more years in the last two weeks, as compared to one in the entire previous history of baseball.
What factors are behind this hot new contract structure? Did a financial consultant walk through the Winter Meetings whispering “long contracts are in, pass it on” to team employees? I truly wish that were the case. It could be my big break in starting up Ben Clemens Investigates, and I’ve always wanted to wear a Sherlock Holmes hat. Bad news, though: to the best of my knowledge, that didn’t happen. It didn’t have to happen. The incentives to offer long-term deals are mathematically based, and I’m frankly pretty annoyed that I didn’t see this coming in predicting contracts this offseason.
A year ago, 10-year rates were at 1.48%. Two years ago, they were 0.9%. The value of $100 in 10 years is on a steady decline, in other words. A 10-year deferred $100 dollar payment was worth $91.43 in December 2020. It was worth $86.34 in December 2021. It’s down to $70.14 today. Interest rates are rising, which means money in the future commands a greater premium on money today.
There’s an intuitive link between inflation and interest rates. If you’ve bought anything at all in the past year, you’ve surely noticed the wave of inflation sweeping across the world. Let’s say I told you that everything would cost 5% more next year, then asked you what rate of interest you’d accept to lend me money for a year. You’d probably want 5% or so, so that your money could buy as much in the future as it can buy now. Maybe you’d want slightly more because you currently have a use for that money, or maybe slightly less because you don’t have anything else to do with it, but the general link between expected inflation and interest rates is intuitive.
Finance people, earmuffs: I’m about to get very lazy in the service of easily understandable math. Let’s assume that interest rates are constant with a flat yield curve, 3.61% for every maturity of bonds. That’s decidedly not how the yield curve looks in real life, but introducing extra complexity here is simply not worth it. That means that you’d need to put $25.98 million into one-year bonds, because $25.98 million times 1.0361 works out to $26.92 million. You’d need to put $25.08 million into two-year bonds, because $25.08 million times 1.0361 twice — one for each year of growth — works out to $26.92 million. It goes on like that, down the line, until you’ve paid out all 13 years of the deal.
At an interest rate of 3.61%, the Giants would have to put away $285.4 million today to secure Correa’s payments for the next 13 years. By the time they’re paying for the last year of the deal, they’d only need to invest $17.59 million today; compounding interest is a powerful force. But lower interest rates change the equation meaningfully. At 2021’s prevailing rates, they’d need to invest $320.9 million to fund a 13-year, $350 million commitment. At 2020’s rates, they’d need to invest $331.8 million. The cost of Correa’s contract, at least in present value dollars, has declined significantly thanks to rising interest rates. If you’re a team discounting everything to present value, the Correa deal looks $50 million smaller than it would have under 2020 interest rates. That’s a massive difference.Sometimes it seems as though teams flip their contract preferences all at once by magic.
In reality, though, macroeconomic conditions have a huge role to play in team preferences. The lever is a simple one, and one that any of thousands of first-year financial analysts know implicitly. Higher interest rates? Push your liabilities further into the future, even if it means paying a higher total amount of dollars. Lower interest rates? Future liabilities hurt more, so keep contracts short. Teams have plenty of financial analysts of their own, and team ownership groups are no rubes. If you’re wondering what’s driving league trends, look at bond yields