Why Are Teams Issuing Extremely Long Contracts?

© Brad Rempel-USA TODAY Sports

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.

Let’s start things off with a graph, courtesy of FRED. That’s not early baseball legend Fred Pfeffer, or even recent Hall of Fame inductee Fred McGriff; it’s F.R.E.D., Federal Reserve Economic Data, maintained by the St. Louis Fed. Here are 10-year treasury rates over the past three years:

A useful and only slightly wrong way to think about this chart is that it’s the risk-free interest rate you can receive on money for the next 10 years on a given day. That’s not quite right thanks to the vagaries of bond math and various arguments about risk premium, coupon frequency, and reinvestment, but it’s close enough for our purposes.

You can do some neat stuff with that number. One obvious use case is to figure out how much $100 today will be worth in 10 years. As of December 12, that rate stood at 3.61%. In other words, you could expect your $100 today to be worth $100*(1.0361^10), or $142.57, in 10 years. Every year, you earn 3.61% interest; in other words, your money turns into 1.0361 times itself. Do that 10 times, and you’re 10 years in the future. You can also go backwards using the same formula. How much is $100 in 10 years worth in today’s money? It’s worth the amount that you’d have to invest today to have $100 dollars in 10 years, of course. That works out to $70.14, because $70.14*(1.0361^10) comes out to $100.

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.

There are more factors at play, and I’m certainly oversimplifying, but if you think that high inflation generally means high interest rates, you’ll do just fine. From that perspective, it’s no surprise that interest rates have gone up. I already showed the meteoric rise in interest rates, but inflation has increased markedly too. Here’s a rough comparison to the earlier chart, the seasonally adjusted annual rate of inflation as calculated by the Cleveland Fed:

That’s very close to the same time period as the graph of 10-year interest rates. It undersells the sudden increase, though, particularly when you compare it to inflation, interest rates, and the general time value of money over the past 10 years. Here’s a 10-year graph of annual inflation from the same source:

Two percent, two percent, two percent, explosion. From that perspective, it’s no wonder that contracts look different than they have for the past decade of superstar payouts.

Here’s a way of thinking about it that might help relate my rambling about interest rates to teams’ increased desire to go long on contracts. Let’s say that the Giants wanted to offer Carlos Correa his 13-year, $350 million contract, and buy enough bonds today to fund the entire contract. In other words, they’d buy enough one-year bonds to have $26.92 million dollars in a year, enough two-year bonds to have another $26.92 million in two years, and so on. They’d also just give him $26.92 million today, of course. It’s a simplification of how contract payments work, but again, it’s just for the purposes of illustration.

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.

Another way of thinking about it that’s slightly more convoluted, but lets me do some fun math tricks. Let’s assume that the Giants were either going to offer Correa the biggest deal they could afford by investing $300 million dollars over 13 years, or 67.8% of that money over six years. Why 67.8%? That’s how much of Correa’s next 13 years of WAR he’s projected to accrue in the next six years. WAR isn’t inflationary — there’s the same amount of it in every year — so presumably 67.8% of the WAR merits 67.8% of the present value of the contract.

At 3.61% interest rates, they could offer him either a 13-year deal worth $367.9 million, an average annual value of $28.3 million, or a six-year deal worth $193.7 million, an average annual value of $37 million. These seem close to me; I think I’d prefer the long-term one. [Note: this example contained an incorrect description of the shorter contract before. It and the following comparisons have been updated to account for the error.]

If interest rates were instead 1.41%, as they were last year, the deals would look different; he’d be picking between 13 years at $25.1 million per year and six years at $35.1 million per year. That’s a $3.2 million per year pay cut on the longer deal, and only $1.9 million on the shorter deal. At 0.9% interest rates, it’s either $24.3 million per year for 13 years or $34.6 million per year over six years. The lower the prevailing interest rate, the more attractive in raw dollars the shorter deals sound.

So are owners just duping players with long-term deals at a time of higher interest rates? Not exactly. For one, owners are guaranteeing more money, which is a pretty clear win for players. For another thing, not everyone has the same time value of money. If you’re a player, you might want to invest any money you got upfront into risk-free assets, or perhaps just keep it in a bank account. Teams, on the other hand, can’t borrow at the risk-free rate. Liberty Media, the parent corporation of the Braves for at least a little while longer, has a credit rating of BB-. Again per FRED, those 10-year yields are around 6.5% today and crested 7% earlier this fall. Teams might discount the present value of future payments by even more than my estimates.

If that doesn’t make sense to you, think of it as Correa issuing the Giants a loan as part of his contract. If they paid him based on his contributions each year, he’d get the lion’s share of his money upfront. He’s taking less than his contributions in the early years of the deal, and getting that money back with some interest in the later years. If the rate implied in Correa’s contract works out to a 4% loan, but they’d have to pay 7% on the open market, everyone can be a winner. He gets a better rate than he would by investing in 10-year treasuries, and they get a better rate than they would have by issuing debt. That only works if the deal is long-term; there’s not much benefit to be had in a five-year loan relative to a 13-year one.

That can be a fine deal for both Correa and the team. Even if the team weren’t planning on borrowing money to issue contracts — and it probably isn’t — these longer-term deals let it move production to the present and cost to the future at a good rate on both. The higher interest rates go, the more this kind of deal makes sense. For the same present value of money, teams can present longer deals with higher guarantees, which sounds like exactly what players are always clamoring for. The present value might work out the same, but the headline numbers look decidedly different.

I don’t advise teams on financial optimization. If I did, though, I’d be telling them to do exactly what they’ve been doing over the past two years. In 2020 and ’21, short-term deals were the flavor of the day, because interest rates were extremely low, which made those future commitments onerous. In today’s higher-rate world, deferring payments far into the future is relatively more attractive.

But wait, there’s more! As Zach Crizer noted for Yahoo Sports, extending the length of contracts minimizes their competitive balance tax hit per year. Average annual values allocated to free agents have barely budged this year, even as total dollars allocated have skyrocketed. That lets teams dodge tax bills now while the talent they sign to deals plays at a higher level than their salary would suggest.

Will those bills come due one day? Sure, but the new shape of the CBT helps to offset that. In the most recent CBA, the league and the MLBPA agreed to a competitive balance tax that ratchets up over time, from an initial threshold of $230 million in 2022 to $244 million in ’26. The inflationary environment likely means that future bargaining won’t slow the pace of increases. That’s a big change from the way the CBT worked before 2022; from 2014 to ’21, it only moved from $189 million to $210 million.

The more the CBT increases, the less onerous an individual contract will be in the future. Saving on your tax bill now is also a huge deal given higher interest rates. Take the Mets, for example, and their deal with Brandon Nimmo. If they managed to lower his AAV by, say, $5 million by offering him extra years, that saves them $4.5 million in tax outlay today; their marginal CBT rate is 90%. That $4.5 million invested even at risk-free rates for five years turns into $5.4 million in five years. The Correa deal is the same idea taken to an extreme; by the time Correa’s deal is ending, tax levels will likely be meaningfully higher than they are now, and any tax savings his long-term deal has granted the team will compound up in the meantime.

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 (a sentence I never thought I’d write).

Ben is a writer at FanGraphs. He can be found on Twitter @_Ben_Clemens.

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1 year ago

I must say, my head was hurting through some parts, but this is a terrific article.

1 year ago
Reply to  zstam

Agreed. Way too much before coffee.