Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-

Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-

rity issued by the borrower. Commercial paper notes have denomina- tions (face values) starting at $25,000 each, although most have denominations of $100,000 or larger.

Commercial paper is unsecured, so the lender (the party buying the commercial paper) is counting on the borrowers ability to pay the face amount of the note at maturity. Nevertheless, almost all commercial paper is backed up by a line of credit from a bank. If commercial paper is backed and the borrower is unable to pay the lender at maturity, the bank stands ready (for a fee) to lend the borrower funds to pay off the maturing paper.

Most commercial paper notes issued in the U.S. have maturities from

3 to 270 days. Why? Because if a security has a maturity over 270 days, the issuer must register the security with the Securities and Exchange Commission. Doing so would delay the issuance and increase the cost of issuing the paper. Though these maturities are relatively short, some firms tend to use commercial paper for financing over longer periods of time. They do this by rolling over the paper—as the paper matures, they issue new commercial paper to pay off the maturing commercial paper.

EXHIBIT 21.6 Comparison of the Cost of Alternative Financing Arrangements

Effective Cost Alternative

Financing

Beginning of the

End of the

Arrangement

Year Cash Flow

Year Cash Flow of Financing

1 A loan with a single interest rate of 10% $100,000 cash available → $110,000 paid to the bank 10.00%

2 A loan with a 10% discount $100,000 cash available → $111,111 paid to the bank 11.11%

3 A loan with a single interest payment of $100,000 cash available → $125,000 + 12,500 – 25,000 = 12.50% 10% and a 20% compensating balance

$112,500 paid to the bank 4 A $150,000 line of credit from which

$100,000 cash available → $100,000 + 10,000 + 500 = 10.50% any borrowings incur a single interest

$110,500 paid to the bank payment of 10 percent; in addition, there is a 1% fee on any unused credit

Management of Short-Term Financing

Finance companies and nonfinancial companies issue commercial paper. Finance companies, such as General Motors Acceptance Corpo- ration (GMAC) and C.I.T. Financial Corporation, are in the business of lending funds to consumers, usually for consumer durables such as automobiles. Finance companies tend to continually roll over their com- mercial paper since it is the major source of funds to use for their lend- ing business. Nonfinancial companies are not finance companies, but instead are manufacturing firms and public utilities. They tend to issue commercial paper to meet their seasonal financing needs.

Commercial paper is classified as either direct paper or dealer paper. Direct paper is sold by an issuing firm directly to investors without using a securities dealer as an intermediary. The vast majority of the issuers of direct paper are financial firms. Because financial firms require

a continuous source of funds in order to provide loans to customers, they find it cost effective to establish a sales force to sell their commer- cial paper directly to investors. Direct issuers post rates at which they are willing to sell commercial paper with financial information vendors such as Bloomberg, Reuters, and Telerate. In the case of dealer-placed commercial paper, the issuer uses the services of a securities firm to sell its paper.

Although commercial paper is a short-term security, it is issued within a longer term program: U.S. commercial paper programs are often open-ended. For example, a company might establish a five-year commercial paper program with a limit of $300 million. Once the pro- gram is established, the company can issue commercial paper up to this amount. The program is continuous and new commercial paper can be issued at any time, daily if required.

The interest on commercial paper is generally stated as discount interest, though in recent years some commercial paper with single pay- ment interest—interest bearing—has been issued. The interest is quoted on the basis of a 360-day year and is fixed for the maturity of the paper.

All investors in commercial paper are exposed to credit risk. Credit risk is the possibility the investor will not receive the timely payment of interest and principal at maturity. While some institutional investors do their own credit analysis, most investors assess a commercial paper’s credit risk using ratings by a Nationally Recognized Statistical Rating Organizations (NRSROs). The SEC currently designates only Moody’s, Standard & Poor’s, and Fitch as NRSROs for rating U.S. corporate debt obligations. Exhibit 21.7 presents the commercial paper ratings from the NRSROs.

MANAGING WORKING CAPITAL

EXHIBIT 21.7 Ratings of Commercial Paper

Fitch Moody’s S&P

Superior F1+/F1 P1

A1+/A1

A2

Satisfactory F2 P2

A3

Adequate F3 P3

Speculative F4 NP

B, C

Defaulted F5 NP

The risk that the investor faces is that the borrower will be unable to issue new paper at maturity. As a safeguard against “rollover risk,” commercial paper issuers secure backup lines of credit sometimes called “liquidity enhancement.” Most commercial issuers maintain 100% backing because the NRSROs that rate commercial paper usually require a bank line of credit as a precondition for a rating. However, some large issues carry less than 100% backing. Backup lines of credit typically contain a “material adverse change” provision that allows the bank to cancel the credit line if the financial condition of the issuing firm deteriorates substantially. 2

Historically, defaults on commercial paper are relatively rare. As of the end of 2001, the last default of any consequence occurred on Janu- ary 31, 1997 when Mercury Finance Co.—a sizeable player in the auto- mobile lending business—defaulted on $17 million in commercial paper. The amount of paper in default mushroomed to $315 million by the end of the next month. Fortunately, the Mercury default inflicted minimal damage on commercial paper market.

The commercial paper market is divided into tiers according to credit risk ratings. The “top top tier” consists of paper rated A1+/P1/ F1+. “Top tier” is paper rated A1/P1, F1. Next, “split tier” issues are rated either A1/P2 or A2/P1. The “second tier” issues are rated A2/P2/ F2. Finally, “third tier” issues are rated A3/P3/F3.

The cost of commercial paper varies along with other market inter- est rates, such as the rate on a 3-month Treasury bill. In addition to gen- eral market rates, the credit rating of the issuer of commercial paper affects the cost of this form of financing. Specifically, the higher the credit rating, the lower the cost.

2 Dusan Stojanovic and Mark D. Vaughan, “Who’s Minding the Shop?” The Re- gional Economist, The Federal Reserve Bank of St. Louis (April 1998), pp. 1–8.

Management of Short-Term Financing