Getting Started in Commercial Paper

While approximately half of the states allow investing public funds in commercial paper (CP), it has not enjoyed the widespread acceptance of other money market instruments such as agencies or certificates of deposits. Despite this, the inclusion of high-quality CP can be a part of a diversified investment portfolio.

The CP Market. Commercial paper is a short-term unsecured note issued in the open market, typically used for financing a corporation's shorter-term needs like working capital or bridge loan financing. While numerous options exist in the capital markets for longer-term financing, short-term financing needs have been often met through bank loans. In recent years, the CP market has emerged as a cost-effective alternative to bank loans. Issuers are primarily corporations, although municipalities can access this funding source to issue tax-exempt debt. As an unsecured obligation, issuers pledge no assets and only the liquidity and earnings power of the issuer can be counted on for repayment.

Originally limited to entities with the highest credit ratings, credit enhancements and collateralization have allowed lower-rated corporations to access the CP market. In such situations, a financial institution with a high credit rating provides a letter of credit for a fee, thereby substituting its own high credit rating for that of the issuer. In addition, collateralization by high-quality assets for asset-backed CP can be used. From the investor's perspective, credit quality depends on the underlying enhancement or collateralization and the bank's creditworthiness. Depending on the structure, the credit of the issuing corporation can be overlooked.

The maturity of CP is typically less than 270 days. Special provisions of the Securities Act of 1933 exempt CP from registration with the SEC if its maturity does not exceed this 270-day threshold. Because of this exemption, CP has become a viable alternative to bank borrowing. CP is quoted on a discount basis like Treasury Bills. Interest rate calculations use a 360-day year.

Issuers typically reissue or roll CP over and use the proceeds to pay off holders of maturing paper. The risk that an investor faces in this scenario is that the issuer will be unable to issue new CP to refinance the maturing CP. This can occur either due to an issuer-specific event or as a result of a broader, marketwide disruption. To mitigate against this risk, commercial paper is usually backed by bank lines of credit.

Procuring CP. Rating agencies assign CP ratings, taking into account the provisions for credit enhancement liquidity. The highest rating (A-1+ for S&P and Prime-1+ for Moody's) reflects a strong degree of safety concerning timely payment. Public investors should limit themselves to the top credit ratings.

CP is classified either as “direct paper” or “dealer paper.” Direct paper is sold by the issuer directly to investors without the use of an intermediary. Large issuers requiring continuous funds often opt to place direct paper, finding it more cost-effective to establish their own marketing program and bypass the dealer commission. Dealer-placed paper, on the other hand, is sold through a securities dealer. Numerous resources exist to facilitate investing in commercial paper, such as GFOA YieldAdvantage.™

CP yields track those of other money market instruments but they tend to be higher than comparable maturity treasury or agency instruments. The primary reason for this yield premium is CP credit risk. Also, while interest earned on treasury instruments is exempt from state and local taxation, commercial paper is fully taxable. Consequently, the yields are higher to offset this tax-disadvantage. In addition, there is a less active secondary market and thus a slight liquidity premium for CP.

The spreads between CP and Treasuries or between CP of different ratings change over time depending on various factors. When the money supply is tight, investors have a tendency to become more concerned about credit risk, turning to safe havens, which drives up the price of treasuries while driving down their yields, resulting in spreads widening. During these periods of restrictive monetary policy, a flattening yield curve is often accompanied by widening commercial paper spreads. In the alternative, during periods of easing, investors tend to abandon higher quality securities in an attempt to capture yield, effectively driving down spreads between the risk-free Treasuries and CP.

Issues to Keep In Mind. Investors should always be aware of the level of risk they are accepting. On the spectrum of credit risk, CP ranks behind both Treasuries and agencies. Investing in the highest-rated paper helps mitigate credit risk.

Like all fixed income securities, CP is susceptible to fluctuations in interest rates, also known as market risk. If interest rates rise, CP prices will decline. However, the relatively short maturity of the paper limits the potential price erosion.

Finally, the topics of risk, liquidity and yield should be contemplated in the context of a well-diversified portfolio. The investor should ascertain whether the additional yield, or spread of CP over other comparable maturity instruments, adequately compensates for the additional risk taken for a given maturity.

Sofia Anastopoulos, CFA is sales manager, GFOA YieldAdvantage.™ She can be reach at Sanastopoulos@gfoa.org or 312/578-2292.

Panel of Economists

Sustained Growth Seen, Despite More Rate Hikes

This month, Public Investor asked its panel of economists to provide readers with their forecast of the economy over the next six months, commenting specifically on economic growth, inflation, and interest rates. Although economic growth and inflation are expected to be moderate, the economists see more rate hikes in the offing.

Carl Tannenbaum's outlook calls for real growth in gross domestic product of 3 to 3.5 percent for the second half of 2005. He expects some moderation in housing activity, but job creation will enable consumers to support the continued expansion of the economy. At the same time, inflation should remain under control and energy price increases should slow somewhat. Despite the moderate growth and inflation, Tannenbaum predicts that the Federal Reserve will raise rates at least three more times this year.

Compared to Tannenbaum, John Silvia predicts that the economy will grow at a slightly more tepid rate of 3.25 percent, and inflation will remain steady at 2.5 to 3 percent. He expects that the Federal Reserve will raise the Fed Funds rate to 3.75 percent by the end of the year, and for the benchmark 10-year Treasury bond to be in the 4.5 to 4.7 percent range over the following six months.

Expansion Extends to All Regions

The Fed “Beige Book” reports that business activity continued to expand in all 12 Fed districts, with most districts describing growth as “moderate, solid, or well-sustained.” The Philadelphia Fed's biannual Livingston Survey of economists predicts that the economy will continue this pattern, with real GDP growing at 3.6 percent for the second half of 2005 and 3.1 percent for the first half of 2006.

The databank’s average money market fund maturity—currently 36 days—suggests that short-term interest rates will continue to rise. In contrast, the average maturity over the past 10 years has been around 50 days. Money market fund managers tend to decrease their average maturity when they expect short-term interest rates to rise.

RGM

Fed Not Retreating

The Fed is widely expected to continue its series of measured rate increases by raising the Fed Funds rate 25 basis points to 3.25 percent at its meeting on June 30. The Fed's next meeting is on August 9, where it is also expected to raise rates 25 basis points. The Fed Funds futures market projects that the central bank will continue to the rate hikes through the rest of the year. Although the Fed has raised rates about 200 basis points in the past year, the real Fed Funds rate is still about 100 to 150 basis points below the historical average.

The Livingston Survey predicts that the three-month Treasury bill will rise to 4.2 percent over the next 12 months and then level off. The survey predicts that the 10-year Treasury bond will rise to 5.1 percent over the next 12 months and also level off at that point.

RGM

6-Month Treasury Bill
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30-Year Treasury Bond

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The information and opinions printed herein are from sources believed to be reliable, but GFOA makes no guarantee of accuracy. Opinions, forecasts and recommendations are offered by individuals and do not represent official GFOA policy positions. Nothing herein should be construed as a specific recommendation to buy or sell a financial security.