Commercial Paper

This reading compares the short-term funding sources open to nonfinancial companies and to financial institutions, explains how repurchase agreements work, and contrasts long-term funding for investment-grade and high-yield issuers. A candidate must be able to rank lines of credit by reliability, compute a repo's purchase price, haircut, repurchase price and variation margin, and state how high-yield issues differ from investment-grade issues.

LOS 54.a — Short-term funding alternatives

Nonfinancial corporations

A nonfinancial company funds short-term assets (cash, short-term investments, receivables and inventory) through intermediaries. The intermediaries supply this funding in two forms: loan financing and security-based financing.

Bank lines of credit let a borrower draw funds as needed, usually at a floating market reference rate (MRR) plus a fixed credit spread.

Banks hold more regulatory reserves against committed lines. They manage that risk by keeping commitments under one year or by lending in a syndicate.

• Secured (asset-backed) loans: weaker borrowers pledge fixed assets, receivables or inventory as collateral. Receivables can also be assigned to a lender as collateral.
• Factoring: the company actually transfers its receivables, together with the credit-granting and collection functions, to a factor, which pays less than face value. The discount is effectively the interest rate and depends on the customers' creditworthiness and on collection costs.
• Commercial paper (CP): short-term unsecured debt issued by large, highly rated firms, usually maturing in under three months. For these issuers it is cheaper than a bank loan. CP funds working capital and serves as bridge financing until permanent (long-term) financing is arranged. CP is normally rolled over at maturity. The danger of being unable to sell new paper to repay maturing paper is rollover risk, which issuers manage with backup lines of credit (liquidity enhancement). US CP is a pure discount security, like a T-bill. A smaller, less liquid international market is Eurocommercial paper (ECP).

Financial institutions

• Deposits: demand deposits (checking accounts, immediate access, usually no interest), operational deposits (large customers needing cash management, custody and clearing) and savings deposits, which carry a stated term and interest rate. A certificate of deposit (CD) has a stated rate and maturity of less than a year. A nonnegotiable CD carries a penalty for early withdrawal. A negotiable CD can be sold in the open market, and wholesale negotiable CDs, traded in domestic bond markets and in the Eurobond market, are an important bank funding source.
• Interbank funds: loans from one bank to another for one day to one year, secured or unsecured, priced off an MRR such as SOFR. The most common secured form is the repo.
• Central bank funds market: banks with excess reserves at the central bank lend them to banks that are short. The rate is the central bank funds rate, which the central bank's open market operations strongly influence. Borrowing directly from the central bank as lender of last resort ("discount window lending") costs more and brings extra scrutiny.
• CP and ABCP: financial institutions issue more CP than nonfinancial companies. They also sponsor asset-backed commercial paper (ABCP), which is created in two steps. (1) The bank transfers short-term loans it has made to an off-balance-sheet special purpose entity (SPE) in exchange for cash. (2) The SPE sells ABCP to investors, who take on the risk and return of those loans, and the bank provides a backup liquidity line.

LOS 54.b — Repurchase agreements

In a repurchase agreement (repo), one party sells a security and commits to repurchase it at a later date for a higher price fixed in advance. Economically, the security buyer lends cash to the security seller and holds the security as collateral.

The repo rate is the annualized interest rate implied by the gap between the repurchase price and the purchase price. The borrower keeps the economic benefits of the bond, such as coupons, during the term.

Initial margin protects the lender. Collateral worth more than the loan must be posted, so the loan is a discount to the market value:

The loan value grows at the repo rate. If the collateral's value drops below (accrued loan value × initial margin), the lender calls for variation margin:

A negative result signals overcollateralization, so the borrower may request the return of some collateral.

1. Loan amount: the purchase price is $40,000,000/1.05=\$38,095,238$.
2. Haircut: $1-1/1.05=4.76\%$.
3. Amount due on the repurchase date: $38,095,238\times (1+0.03\times 30/360)=\$38,190,476$.
4. Margin check during the term. After 10 days the loan has grown to $38,095,238\times (1+0.03\times 10/360)=\$38,126,984$, so the required collateral is $38,126,984\times 1.05=\$40,033,333$. If the collateral is then worth $39.4 million, the borrower must post variation margin of about $633,333. If it is worth $40.5 million instead, variation margin is $40,033,333-40,500,000=-\$466,667$, so the borrower can ask for about $466,667 of collateral to be released.

Uses

• Dealers and other financial institutions borrow through repos (as security sellers) to finance their securities positions.
• Banks, mutual funds and pension funds lend (as security buyers) to earn the repo rate on excess cash.
• Central banks lend (buy) to add money and borrow (sell) to drain it.
• Short sellers such as hedge funds buy the security and lend cash in a repo, sell the security short, buy it back later and return it at maturity. A trade entered for the purpose of borrowing a security in this way is a reverse repo from that participant's side. Asking for a specific security is a special trade. For a hard-to-borrow security the lender of cash accepts a lower, sometimes negative, repo rate.

What drives the repo rate?

Because repos are short-term and collateralized, usually by high-quality sovereign bonds, repo rates are normally below bank loan rates.

A repo is safer than most short-term lending, but it is still debt for the borrower, and heavy reliance on it can lead to financial distress. Repos carry default risk (the cash borrower fails to repurchase), collateral risk, margining risk, legal risk, and netting and settlement risk. A tri-party repo helps mitigate many of these risks and improves cost efficiency in accessing, valuing and safekeeping collateral, but it does not reduce credit risk.

LOS 54.c — Investment-grade vs. high-yield long-term funding

With a normal (upward-sloping) yield curve, both investment-grade and high-yield issuers must pay higher yields at longer maturities. The increase is bigger for high-yield issuers because their credit spreads are larger. Issuing shorter bonds to save on yield adds rollover risk.

In the figure, moving from a 1-year to a 10-year issue adds 1.75 percentage points to the investment-grade yield and 3.60 points to the high-yield yield. The government curve rises by only 1.20 points, so most of the extra cost for the high-yield issuer comes from a credit spread that widens with maturity.