Commercial Paper Today

Key Take-aways

• Commercial paper (“CP”) is a short-term, unsecured promissory note with maturities ranging anywhere from 1 to 270 days.
• A relatively short-term, quality investment option, some governments include CP as part of their investment portfolios for diversification and competitive rates of return.
• Moody’s Investors Service (“Moody’s”) recently updated its CP default study for the first time since 2013. Moody’s April 2018 report showed that default rates for highly rated P-1 paper, over a 180-day horizon, have remained unchanged at a rate of 0.02%.
• The default study also showed even in the rare instances when CP defaults did occur, full recoveries (100%) are most common. Whereas, CP program losses have historically been concentrated in Asset Backed Commercial Paper (ABCP) programs, the latest statistics confirm the declining popularity of ABCP programs.

Background

CP is a short-term, unsecured promissory note issued by corporations, typically, for working capital, receivables financing, and other short-term financing needs. Because of the short maturity, under 270 days, federal law exempts CP from registration with the Securities and Exchange Commission (SEC). As unsecured debt issued by companies, CP carries default risk for investors as compared to U.S. Treasury or agency or government sponsored enterprise debt.

Types

CP has evolved tremendously since it was first developed.

Traditional Commercial Paper

CP, in its basic form, is an instrument issued by various entities – usually corporations, both financial and non-financial, to manage their short-term liquidity and working capital needs. Historically, only entities with the highest credit ratings could issue CP. Maturing CP, typically, “rolls over” with investors paid off with proceeds from subsequent new issuances. Of course, the risk with “rolling over” is that unexpected circumstances might interfere with attempts to replace outstanding CP with new CP. This happened during the financial crisis of 2008. To reduce “roll over” risk, back up lines of credit are secured for CP issues. Because of such features, investors perceive CP to be relatively safe and liquid.

Financial innovations in the form of liquidity programs (including extendibility features, credit enhancements, as well as various special legal structures) have made CP a viable financing alternative for entities with lower credit ratings. Accordingly, while investors traditionally depended on the financial strength of the issuing entity, increasingly, the credit support backing a CP issue, as well as the legal structure of the issuing entity, have become an important part of the investment.

Asset-Backed Commercial Paper

ABCP was a natural progression in the evolution of CP and gained popularity because of concern over the unsecured status of CP. Put simply, in ABCP programs, certain assets and their cash flows support a CP issue. ABCP is usually sold through a conduit, which is an entity established to facilitate the custody of assets and the direction of the cash flows.

Multi-Seller, Asset-Backed Vs. Single-Seller, Asst Backed

In general, banks establish conduits called special purpose vehicles (SPVs). The SPV then becomes the legal issuer of such CP. There are different structures for such conduits. Some SPVs pool the assets of many entities from various or diversified industries. These multi-seller ABCP programs issue CP backed by the cash flows from all the underlying assets. The goal of such multi-seller programs is to diversify from multiple sellers in various industries.

Single-seller ABCP programs are backed by the assets of one entity, for example a corporation. Consequently, they lack the diversification of multi-seller programs.The sponsoring bank evaluates the assets on behalf of its SPV, provides liquidity and credit enhancement, and structures and administers the program's cash flows. Such programs have provided an alternative funding source for a bank's customers, while generating fees for the bank. An SPV would be ongoing and not wind down (unless certain trigger events occur). Instead, maturing CP is rolled over. Simultaneously, the proceeds from maturing receivables are used to buy newly generated receivables, which support the ongoing, ever-green CP issuance.

Historically, ABCP was considered a relatively safe short-term investment due to the support of the underlying assets and cash flows. Although interest in ABCP peaked at approximately 50 percent of the overall CP market before the financial crisis, interest has since waned.2

Structured Investment Vehicle

The ABCP market has evolved to serve a variety of needs other than the traditional funding purpose. One of these developments is the structured investment vehicle (SIV). Some SIVs take advantage of spread differentials in fixed income securities, earning interest rate arbitrage profits. Banks or hedge funds sponsor SIVs to issue relatively short-term and low-cost asset-backed commercial paper, which is used to purchase longer-term and higher yielding securities or assets. Some SIVs have extended their funding beyond the 270-day commercial paper maturity, issuing medium-term notes.

SIVs invest in various asset categories, including: mortgage-backed securities; collateralized debt obligations, which are pools of bonds and mortgages; and asset-backed securities, which are pools backed by auto loans, credit card receivables, and a variety of mortgage-related loans. Such assets are difficult to value because they do not trade on any active market. Lacking such a market, their value is based on models that are sensitive to a number of assumptions.

The turmoil in the U.S. housing and mortgage market during the financial crisis had a direct effect on such assets. Because of the opacity of SIV portfolios, practically all the SIVs were unable to issue new debt or roll over their commercial paper. Forced to raise cash to pay maturing CP, the SIVs were forced to liquidated their underlying assets, which put further negative pricing pressure on these assets. One of the side effects of the SIV CP experience was the frightening away of investors from the more traditional forms of CP.

NRSRO Involvement

Nationally Recognized Statistical Rating Organizations (NRSRO) issue credit ratings on CP. The SEC permits these ratings to be used by other financial firms and investors for certain regulatory purposes. For example, under SEC rules, money market funds may invest only in CP that has been rated in the top two categories of creditworthiness by an NRSRO.

Implications for Investors of Public Funds

While default rates have remained stable and relatively modest through its history, government investors should be mindful of risks in CP. The GFOA Advisory, “Using Commercial Paper in Investment Portfolios,” advises governments to limit their CP investing to paper that has received a first-tier rating by two NRSROs . However, the due diligence and decision-making process of government investors must go beyond relying on NRSRO ratings. Investors of public funds must remain vigilant about what they buy. Investors who lack the expertise to invest in CP may chose to refrain from CP investing or participate in CP through funds or investment advisers.

Tips for Prudent Investing in Commercial Paper

To protect public funds invested in commercial paper, government investors should consider the following practices:

• conducting their own ongoing financial reviews of commercial paper issuers, including periodically reviewing balance sheet information for issuers of traditional CP as well as reviewing monthly or quarterly pool reports for ABCP.
• Diversification by industry sector or type.
• Limitation on percentage of portfolio comprised of commercial paper.
• Limitation on percentage of commercial paper issued by any one issuer, industry, or type.
• Limitation of investments to shorter maturities reflecting the most active part of the commercial paper market and providing the least opportunity for credit quality changes.
• Restricting investments in sectors or industries experiencing turmoil, volatility or changes such as major regulatory or technological changes
• Recognizing different types of commercial paper, such as corporate promissory notes, asset- backed paper, funding paper, or extendible paper (also called liquidity notes or structured notes) and determining the appropriateness of each for the government's portfolio. •Limitation to first tier short-term credit ratings by two NRSROs (for example, A-1, P-1, F-1 or better).
• Evaluation of underlying credit enhancements such as bank lines of credit or insurance in addition to the dual credit ratings. Maintenance of information on each commercial paper issue in the portfolio. •Monitoring of ratings and rating outlook analyses.
• Establishing a short pre-approved list, monitored frequently, of CP that investment staff is limited to purchasing.