Commercial Paper
Commercial paper is the most prevalent
form of security in the money market, issued at a discount, with a yield
slightly higher than Treasury bills. The main issuers of commercial paper are
finance companies and banks, but also include corporations with strong credit,
and even foreign corporations and sovereign issuers. The main buyers of
commercial paper are mutual funds, banks, insurance companies, and pension
funds. Because commercial paper is usually sold in round lots of $100,000, very
few retail investors buy paper.
Commercial paper are unsecured
promissory notes for a specified amount to be paid at a specified date, and are
issued by finance companies, banks, and corporations with excellent credit.
They are issued at a discount, with minimum denominations of $100,000. The main
purchasers are other corporations, insurance companies, commercial banks, and
mutual funds. Terms range from 1 to 270 days.
Finance companies sell 2/3 of the total
commercial paper, and sell their issues directly to the public. But
corporations that borrow less frequently sell their commercial paper—called industrial
paper—to paper dealers, who then sell them at a markup to other
investors. A round lot for a paper dealer is $250,000.
Purpose
of Issuance
While creditworthy corporations can
borrow from banks for the prime rate of interest, they may be able to
borrow at a lower rate by selling commercial paper. Commercial paper is also
sold to provide seasonal and working capital for corporations, to provide bridge
financing until longer term securities are sold or until money is expected to
be received, such as tax receipts, and to finance the purchase of other
securities. CDOs and SIVs,
for instance, use commercial paper to finance the purchase of mortgage-backed
securities (MBSs), profiting from the difference of
receiving the higher yield of MBS securities, and paying the lower yield of
commercial paper.
As an example of bridge financing, a
corporation may project that interest rates will be lower in the future, but,
for business reasons, may want to finance a project immediately. It can finance
the project immediately by issuing commercial paper with a maturity that
coincides with the projected lower interest rates. Then it can issue long-term
bonds, and use the proceeds to pay for the redemption of the commercial paper.
Issuers
Issuers can be divided into financial and
nonfinancial companies, although most issuers are financial. There are 3 types
of finance companies:
1. captive finance
companies,
2. bank-related finance
companies,
3. independent finance
companies.
Captive finance companies are subsidiaries
of manufacturers, with the purpose of providing financing for the manufacturer.
The largest selling of commercial paper—General Motors Acceptance Corporation
(GMAC)—is also a captive finance company that provides financing for the
customers of General Motors. Other vehicle manufacturers also have captive
finance companies to promote the sale of their vehicles.
Bank holding companies general use
finance companies to cater to customers with weaker credit. Independent
finance companies are not affiliated with any other company or bank—hence,
the name.
Generally, only corporations with the
highest credit rating can issue commercial paper. Some companies with weaker
credit can get credit enhancements, so that they
can issue commercial paper. Asset-backed commercial paper is backed by
high quality collateral. Credit-supported commercial paper is often
guaranteed by an organization with excellent credit, such as a bank. Often, a letter of
credit is used for this purpose, which is referred to as LOC paper. The bank
promises to pay the face value of the paper if the issuer doesn't. Though the
bank generally charges a fee equal to 1/2 of 1% of the issue, it is still
cheaper than obtaining a loan from the bank.
Other costs that the issuer must pay are
agents' fees to a bank for doing the paperwork necessary to issue commercial
paper, and thousands of dollars to have the issue rated by a credit rating
organization, such as Standard and Poor's and Moody's.
Investment
Characteristics
Most commercial paper has a maturity of
about 45 days, and most are less than 90 days, although some commercial paper
has a maturity of up to 270 days. The terms of the commercial paper is
determined by a number of factors. One factor is the market. Buyers of
commercial paper generally buy the terms that they want to coincide with their
need for money.
The 270-day limit is dictated by the need
to register the security with the SEC if the maturity is longer. This greatly
increases the expense and time to issue—hence, commercial paper will rarely
have terms longer than this. If the issuer needs the money longer, it can
usually rollover the issue by issuing new commercial paper to pay off the
maturing paper, which is often done.
There is also a 90-day barrier for the
length of terms. When a bank borrows from the Federal Reserve Bank discount
window, it must provide collateral. The Federal Reserve will only accept
commercial paper as collateral if it has a term of 90 days or less. This
increases the demand for commercial paper with terms of 90 days or less, and,
therefore, lowers the interest rate that the issuer would otherwise have to pay
for the same term.
Most commercial paper is sold in round
lots of $100,000, although there is some paper available in $25,000 lots.
Commercial
Paper Market
Most commercial paper is bought in the
primary market. The primary market consists of directly placed and
dealer-placed paper. Directly placed commercial paper is sold directly
to the investor by the issuer without the services of a securities firm. Most
issuers of direct paper are finance companies that sell a large amount of
paper continually, and have salespeople to sell the paper to investors.
Dealer paper is issued using
the services of a securities firm, usually an investment bank, but,
increasingly, large commercial banks. Commercial banks were prohibited from
underwriting commercial paper by the Glass-Steagall
Act, but the Federal Reserve, in June 1987, allowed subsidiaries of bank
holding companies to underwrite commercial paper, which has significantly
reduced the costs of issuing dealer paper to the issuer.
Although commercial paper is the most
prevalent money market instrument, the secondary market is very small,
primarily because the terms of commercial paper are very short, and because
buyers of commercial paper usually purchase paper with maturities that coincide
with their need for money. Hence, most holders of commercial paper hold it till
maturity. However, in many cases, if the holder of commercial paper needs the
money sooner, the commercial paper can usually be sold back to the issuer of
direct paper or to the dealer of dealer paper.
Commercial
Paper Yields
Commercial paper is a discount
instrument—the interest earned is the difference between the face value and the
discounted purchase price. Yields are calculated using a banker's year of 360
days.
The yields on commercial paper are
usually 10 to 20 basis points above Treasury bills of the same maturity,
primarily because the interest earned from commercial paper, unlike T-bills, is
not exempt from state and local taxes. Commercial paper also has lower
liquidity than T-bills, where trading in the secondary market is more active
and bid/ask spreads, narrower.
There is also some credit risk. The main
credit risk stems from rollover risk, when the issuer may not be able
to sell new paper to pay for maturing paper, either because the market has
changed, or the credit rating of the issuer has been downgraded. The best
example of this is the recent downgrades of CDOs and SIVs by the credit rating agencies. CDOs
and SIVs made money from mortgaged-backed securities
that were financed with commercial paper. Because the commercial paper has much
shorter maturities than the mortgaged-backed securities, the maturing paper has
to be continually rolled over. But because of the subprime mortgage debacle,
the commercial paper market dried up, especially for the CDOs
and SIVs.
To calculate the investment
yield (aka bond equivalent yield) of commercial
paper so as to compare it to the rates of return of other investments:
1. calculate the
interest rate for the period;
2. then compound the
rate by the number of periods in a year.
|
Formula for Calculating the Investment Yield or
Bond Equivalent Yield (BEY) |
|||
|
|
Interest Rate Per Term |
|
Number of Terms per Year |
|
BEY = |
Face Value - Price Paid |
x |
Actual Number of Days in Year |