Commercial Paper and Medium-Term Notes

1. Commercial Paper

Banks borrow money from one group of firms or individuals and relend the money to another group. They make their profit by charging the borrowers a higher rate of interest than they offer the lender.

Sometimes it is convenient to have a bank in the middle. It saves the lenders the trouble of looking for borrowers and assessing their creditworthiness, and it saves the borrowers the trouble of looking for lenders. Depositors do not care about the identity of the borrowers:

They need only satisfy themselves that the bank as a whole is safe.

There are also occasions on which it is not worth paying an intermediary to perform these func­tions. Large well-known companies can bypass the banking system by issuing their own short-term unsecured notes. These notes are known as commercial paper (CP). Both foreign and domestic financial institutions, such as bank holding companies and finance companies,^[1] also issue com­mercial paper, sometimes in very large quantities. The major issuers of commercial paper have set up their own marketing departments and sell their paper directly to investors, often using the web to do so. Smaller companies sell through dealers who receive a fee for marketing the issue.

Commercial paper in the United States has a maximum maturity of nine months, though most paper is for less than 60 days. Buyers generally hold it to maturity, but the company or dealer that sells the paper is usually prepared to repurchase it earlier.

Commercial paper is not risk-free. When California was mired in the energy crisis of 2001, Southern California Edison and Pacific Gas and Electric defaulted on $1.4 billion of com­mercial paper. And in 2008, Lehman Brothers filed for bankruptcy with $3 billion of paper outstanding. But such defaults are rare. The majority of commercial paper is issued by high- grade, nationally known companies,^[2] and the issuers generally support their borrowing by arranging a backup line of credit with a bank, which guarantees that they can find the money to repay the paper.^[3]

Because investors are reluctant to buy commercial paper that does not have the highest credit rating, companies cannot rely on the commercial paper market to always provide them with the short-term capital that they need. For example, when the rating services downgraded the commercial paper of Ford and General Motors, both companies were forced to sharply reduce their sales of paper.

When Lehman Brothers filed for bankruptcy in September 2008, the commercial paper market nosedived. The spread between the interest rates on commercial paper and Treasury bills doubled, while the market closed entirely for low-grade issuers. Many firms that found themselves shut out of the commercial paper market rushed to borrow on their bank lines of credit. Firms that had no such alternative source of borrowing were forced to cut back on their investment plans.^[4] Only after the Fed announced plans to buy large quantities of high-grade paper did the market begin to return to normal.

In addition to unsecured commercial paper, there is also a market for asset-backed commer­cial paper. In this case, the company sells its assets to a special-purpose vehicle that then issues the paper. For example, as the auto companies reduced their sales of unsecured commercial paper, they increasingly relied on asset-backed paper secured by the firm’s receivables. As the customers paid their bills, the cash was passed through to the holders of this paper.

By 2007, asset-backed paper accounted for almost half the commercial paper market, but weaknesses surfaced after a number of banks set up structured investment vehicles (SIVs) that invested in mortgage-backed securities financed by asset-backed paper. Because the buyers of the commercial paper bore the credit risk, the banks had less incentive to worry about the qual­ity of the underlying mortgages. Once it became clear to investors that this quality was very low, many of the SIVs found it impossible to refinance the maturing paper and went into default.

2. Medium-Term Notes

New issues of securities do not need to be registered with the SEC as long as they mature within 270 days. So by limiting the maturity of commercial paper issues, companies can avoid the delays and expense of registration. However, large blue-chip companies also make regular issues of unsecured medium-term notes (MTNs).

You can think of MTNs as a hybrid between corporate bonds and commercial paper. Like bonds, they are relatively long-term instruments; their maturity is never less than 270 days, though it is typically less than 10 years.⁵² On the other hand, like commercial paper, MTNs are not underwritten but are sold on a regular basis either through dealers or, occasionally, directly to investors. Dealers support a secondary market in these MTNs and are prepared to buy the notes back before maturity.⁵³

Borrowers such as finance companies, which always need cash, welcome the flexibility of MTNs. For example, a company may tell its dealers the amount of money that it needs to raise that week, the range of maturities that it can offer, and the maximum interest that it is prepared to pay. It is then up to the dealers to find the buyers. Investors may also suggest their own terms to one of the dealers, and, if these terms are acceptable, the deal is done.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.