Trading and Capital-Markets Activities Manual
Profiles: Commercial Paper
Commercial paper (CP) is a short-term, fixed maturity, unsecured promissory note issued in the open markets as an obligation of the issuing entity. CP is usually issued with maturities of less than 270 days, with the most common having maturities of 30 to 50 days or less. CP is sold either directly by the issuer or through a securities broker. For entities with a sufficient credit rating, CP is generally backed by bank lines of credit or letters of credit. However, some entities with lesser-quality credit will issue CP without credit enhancements. These issues are typically through private placements and are generally not rated. Foreign corporations may also issue CP. Banks are active in the CP market as issuers, investors, dealers, and lenders on lines of credit used to back CP issuance.
In 1996, outstanding CP in the United States totalled approximately $803 billion: about 70 percent was issued by financial companies, 20 percent by domestic non-financial entities, and the remainder by foreign corporations and governments. The CP market grew 14 percent a year on average from 1970 to 1991. Between 1991 and 1996, the market grew by 50 percent.
CHARACTERISTICS AND FEATURES
CP is issued in maturities which range anywhere from a few days to 270 days (the Securities and Exchange Commission (SEC) does not generally require registration of securities due in less than 270 days), depending on the funding needs of the issuer. Most CP matures in less than 30 days. Issuers prefer to issue CP with a maturity of less than 90 days so that banks can use the CP as collateral at the Federal Reserve discount window. Most issuers need ongoing financing and roll the CP over at maturity, using the new proceeds to pay off the maEagle Tradersg CP. The minimum round-lot transaction is $100,000. Some issuers will sell CP in denominations of $25,000. CP is quoted on a 360-day discount basis. A small amount of CP is issued in interest-bearing form; the rate paid on this paper is the quoted discount rate converted to the equivalent simple interest rate. CP is typically issued in bearer form, but it may also be issued in registered form.
CP Credit Ratings
Credit ratings are crucial to the CP market because most investors restrict their CP investments to high-quality CP or will only buy rated CP. The CP ratings are assessments of the issuer's likelihood of timely payment. Table 1 summarizes CP ratings from the major rating agencies.
Superior-rated issues are considered to have a high likelihood of repayment, satisfactory-rated issues are considered to have satisfactory likelihood, and so on. Before they will assign a rating, the credit agencies require issuers to prove that they have adequate short-term liquidity. Some issuers raise their credit ratings by obtaining credit support to guarantee payment, such as a letter of credit (credit-supported commercial paper), or by collateralizing the issue with high-quality assets (asset-backed commercial paper).
Table 1-Commercial Paper Ratings
CP is generally purchased as a short-term, liquid, interest-bearing security. The short maturity structure, low credit risk, and large number of issuers make CP an attractive short term investment alternative for short-term portfolio managers and for the liquid portion of longer-term portfolios. CP is particularly attractive when interest rates are volatile, as many investors are unwilling to buy long-term, fixed rate debt in a volatile interest-rate environment.
Investors wishing to take a position in short term rates denominated in a foreign currency without taking the risks of investing in an unfamiliar counterparty or facing country risk often invest in an instrument such as Goldman Sachs's Universal Commercial Paper (UCP) or Merrill Lynch's Multicurrency Commercial Paper (MCCP). With UCP or MCCP, the dealer creates synthetic foreign-currency-denominated paper by having a U.S. issuer issue CP in a foreign currency. The dealer then executes a currency swap with the issuer, which eliminates foreign-exchange risk for the issuer. The investor is therefore left with a short-term piece of paper denominated in a foreign currency which is issued by a U.S. counterparty, thus eliminating country risk.
Banks and Bank Holding
Companies Bank holding companies (BHCs) are active issuers of CP. The money raised is often used to fund non-bank activities in areas such as leasing and credit cards and to fund offshore branches.
BHCs use commercial paper in sweep programs. On a BHC level, the sweep programs are maintained with customers at the bank level, and the funds are up-streamed to the parent as part of the BHC's funding strategy. Sweep programs use an agreement with the bank's deposit customers (typically corporate accounts) that permits them to reinvest amounts in their deposit accounts above a designated level in overnight obligations of the parent bank holding company, another affiliate of the bank, or a third party. These obligations include instruments such as commercial paper, program notes, and master-note agreements.
DESCRIPTION OF MARKETPLACE
The short-term nature of commercial paper, together with its low credit risk and large number of issuers, makes it an attractive short term investment for many investors. Investment companies, especially money funds, are the largest investors in the CP market. Other significant investors include the trust departments of banks, insurance companies, corporate liquidity portfolios, and state and local government bodies. If CP carries a rating of A-2, P-2, or better, thrifts may buy CP and count it as part of their liquidity reserves.
Issuers of CP include industrial companies such as manufacturers, public utilities and retailers, and financial institutions such as banks and leasing companies. Financial issuers account for approximately 75 percent of CP outstanding, with industrial issuance making up the remainder. Approximately 75 percent of the CP outstanding carries the highest credit rating of A-1/P-1 or better, while only approximately 5 percent of CP outstanding carries a credit rating of A-3/P-3 or below. In the U.S. market for CP, domestic issuers account for approximately 80 percent of issuance, with foreign issuers making up the remainder.
Several large finance companies and bank holding companies place their paper directly with the investor without using a dealer. Approximately 40 percent of all CP outstanding is placed directly with the investor.
The primary market consists of CP sold directly by issuers (direct paper) or sold through a dealer acting as principal (dealer paper). Dealer paper accounts for most of the market. As principals, dealers buy and immediately sell the CP (with a small markup called the dealer spread). Sometimes the dealers hold CP as inventory for a short time as a service to issuers in need of immediate funds. Dealers are mostly large investment banks and commercial banks with section 20 subsidiaries.
Although dealers do not normally inventory positions in CP, at times they will agree to position any paper which the issuer posted but did not sell on a particular day. The amount unsold is usually small, and the positions assumed are usually on an overnight basis only. If the market moves, most issuers give dealers the discretion to sell CP within established bands set by the issuer.
Issuers of CP have their own dedicated sales force marketing their paper. Direct issuers also post their rates on services such as Telerate and Reuters, and often with bank money desks. Sometimes a company sells direct paper under a master-note agreement, under which the investor can buy and sell CP daily, up to a specific amount, for a specific interest rate that is set daily. The return on the master note CP is slightly higher than that on an overnight repo.
The CP market is larger than the market for other money market instruments, but secondary trading is only moderately active. Most investors have purchased CP tailored to their short term investment needs and hold it to maturity. If an investor chooses to sell CP, he can usually sell it back to the original seller (dealer or issuer). Although CP is not traded on an organized exchange, price quotes for most of the significant issues can be obtained from security brokers. Average yields on newly issued CP are published in The Wall Street Journal.
Each issue is priced based on the strength of the credit rating of the issuer. CP is a discount instrument, which means that it is sold at a price less than its maturity value (though occasionally, CP is issued as interest-bearing paper). The difference between the maturity value and the price paid is the interest earned by the investor. When calculating commercial paper, a year is assumed to have 360 days.
The yield on CP tracks that of other money market instruments. CP yields are higher than those offered on comparable T-bills-the higher credit risk is due to less liquidity and the state and local income tax exemption of T-bills. The rate on CP is also slightly higher than that offered on comparable certificates of deposit (CDs) due to the poorer liquidity of CP relative to CDs.
As mentioned above, dealers do not usually inventory positions in CP. When they do, these positions tend to be small and are usually held only overnight. Due to the short-term nature of CP, dealers often do not hedge these open positions. When these positions are hedged, dealers generally use instruments such as T-bill futures or Eurodollar futures to hedge their residual exposure. However, use of these products may subject the dealer to basis risk to the extent that the underlying instrument and the hedge instrument do not move in tandem.
Given that CP is an unsecured obligation of the issuer, the purchaser assumes the risk that the issuer will not be able to pay the debt at maturity. This credit risk is generally mitigated by the financial strength of most issuers and by some form of credit enhancement (unused bank lines of credit, letters of credit, corporate guaranty, or asset collateralization). Historically, the default rate on CP has been extremely low.
As most investors hold CP until maturity, trading in the secondary market is relatively thin. As a result, only the highest-rated issues may be readily marketable in the secondary market. Privately placed CP is subject to further legally mandated restrictions on resale, which presents additional impediments to marketability.
Interest-Rate Risk Like all fixed-income instruments, CP is subject to interest-rate risk. However, this risk is usually minimal given CP's short-term nature.
CP denominated in foreign currency may expose the purchaser to foreign-exchange risk.
The accounting treatment for investments in commercial paper is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 125, which has been replaced by SFAS 140, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' (Both statements have the same title.) Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.)
RISK-BASED CAPITAL WEIGHTING CP
is generally weighted at 100 percent unless it is backed by a bank letter of credit, in which case the asset weight would be 20 percent. Tax-exempt CP may carry weights of 20 percent or 50 percent, depending on the issuer (that is, depending on whether the obligation is a general obligation or a revenue obligation). For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.''
LEGAL LIMITATIONS FOR BANK INVESTMENT
CP is considered a loan to the issuer and is therefore subject to the applicable lending limit of the purchasing institution. One exception would be a general obligation tax-exempt CP, which can be held without limitation. Holdings of CP issued by an affiliate are subject to the limitations of section 23A of the Federal Reserve Act regarding loans to affiliates.
Fabozzi, Frank J., and T. Dessa, eds. The
Handbook of Fixed Income Securities. 4th ed. Chicago: Irwin Professional
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