Credit Ratings
To be able to issue commercial paper, a company has to have the highest credit rating, either AAA or Aaa. Moody's, Standard & Poor's, and other rating agencies determine the credit rating of companies. Institutional investors buy the commercial paper solely on the credit worthiness of the company, with the understanding that the company will buy back the paper with interest at the maturity date.
Say ABC Corp is a large public company with a credit rating of AAA. It funds its cash needs through commercial paper and decides to issue paper for $200 million with a 4% interest rate and a 30-day maturity:
- $200 million × (4% / 12) = $666,666.67
- $200 million + $666,666.67 = $200.67 million
Investors will buy the paper because of ABC's credit rating, but ABC will have to pay $200.67 million to redeem the paper after the 30 days.
Access to the commercial paper market and the investors willing to buy the paper is solely dependent on maintaining the company's credit rating. If its credit rating is downgraded, the cost and interest rate for its paper will increase, and the company could be excluded from selling commercial paper.
Refinancing
Commercial paper usually is issued with maturity dates between 30 days and 270 days. That means that the company has to pay back the money borrowed within a very short period of time. However, most companies who are using commercial paper regularly will just issue new commercial paper to raise the money to retire maturing paper. It can do this as long as its credit rating stays good.
XYZ Corp has $450 million of commercial paper that is maturing in three months. XYZ doesn't want to use any of its cash to retire that maturing issue, so they prepare another batch of commercial paper and start contacting buyers. They issue new commercial paper for $600 million to cover the $450 million due plus interest and to raise additional cash.
Advantages of Commercial Paper
Commercial paper does not require any registration or approvals, which a company needs to issue new stocks and bonds. Commercial paper also does not require any collateral backing up the issuance. Therefore, commercial paper can be easily and cheaply issued. It provides access to institutional lenders for ready cash for those companies that have the necessary high credit ratings.
Commercial paper usually has slightly higher interest rates than lines of credit or short-term loans from banks. For most companies, the higher interest rate is more than offset by the flexibility of using the commercial paper market and not having to pledge collateral for the borrowings.
Large companies with AAA or Aaa credit ratings can use this market to efficiently finance their working capital needs. The market is readily available to use, and they do not have to spend time trying to negotiate additional short-term borrowing from banks.
Disadvantages of Commercial Paper
A company's access to the commercial paper market is only available as long as it's in good financial condition. Bad financial results or bad news can result in a lowering of a company's credit rating or the company being put on watch by the credit agencies. If a company cannot access the market, they cannot refinance the existing commercial paper they have outstanding. This puts them in a crisis mode to sell assets or get bank loans sufficient to retire the commercial paper when it comes due.
Lehman Brothers, a major investment bank, got into trouble in the recession of 2008 because it had bought several mortgage companies that had portfolios of poor mortgages. These mortgages started to default, causing significant losses and write-offs to Lehman Brothers. Their credit rating was put on hold, so they had to buy back billions of dollars of outstanding commercial paper. This eventually led to Lehman declaring bankruptcy and its sale to other companies.
The consequences of a deteriorating credit rating or defaulting on commercial paper are dire and drastic. The company's stock price will drop significantly, losing much of the market value of the company. The investment value of any issued bonds will also drop, making it more expensive for the company to issue new bonds. Default could realistically result in the bankruptcy of the company.
Lesson Summary
Commercial paper are short-term promissory notes issued by large public companies with credit ratings of AAA or Aaa. They sell the commercial paper to institutional buyers, such as large financial institutions, hedge funds, and large multinational companies. Offerings are usually denominated in notes of $100,000, which makes commercial paper unavailable to most individual investors.
The advantage of using commercial paper is that it can be readily available and doesn't require any registration or negotiation. The market is large at over one trillion dollars, and there are ready buyers as long as a company has a high credit rating.
The disadvantage of commercial paper is that the maturity is from 30 days to 270 days, with most commercial paper having only a 30-day life. The company has to be able to have access to the market to refinance its commercial paper when it becomes due. If it has any bad news or financial results that impair its credit rating, the inability to refinance its commercial paper could push the company into bankruptcy.
