Wayne Dass Commercial paper a useful financing mechanism
Commercial paper, or CP, is short-term debt issued by corporates that is unsecured and used to finance short-term liabilities, including inventory and payables.
The original tenor of a CP is less than one year – and less than 270 days in some markets – and it is issued at a discount with the full face value payable on maturity. Because CP is not backed by assets, investors are relying on the creditworthiness of the issuer and the short-term nature of the exposure.
Globally, the CP market has been in existence for over 100 years, and CP has traditionally been used as a low-cost short-term financing instrument to replace or supplement working capital borrowings from the banking system by manufacturing entities.
Over the years, though, the market has expanded to include banking and non-banking financial institutions as CP issuers.
Issuers of CP may seek to increase their liquidity as they may be needing cash in the short- term. Investors in CP may not need cash right away, so they are willing to buy and hold the instrument to increase their cash on hand in the future. It also provides another route to diversification of their investment portfolio.
In many markets, a major benefit of commercial paper is that it does not need to be registered with the securities market regulator, particularly if it is a private placement to limited investors, making it a cost-effective and a simple means of financing. Commercial paper is also easier to deal with compared to the effort, time, and money involved in getting a business loan. It offers issuers the advantage of lower interest rates, depending on their credit rating, while it offers investors an attractive risk-adjusted rate of return.
The approach taken by credit-rating agencies to assign a rating to a CP issue is similar to that taken for long-term debt, with a few additional steps. This is because there is a high linkage between long-term and short-term ratings as short-term debt instruments are frequently rolled over or refinanced, and the ability to refinance on an ongoing basis is tied to the issuer’s long-term rating.
Separate scales are used, though, by the rating agencies for short-term and long-term ratings, and many will provide an indicative mapping between the two scales so that a rated long-term debt issuer can have an idea of where their short-term rating would fall should they decide to issue short-term debt like CP.
After the CP issuer’s underlying credit quality is determined as reflected in its long-term rating, the following additional steps are taken by the rating agency to arrive at the short-term rating for the CP:
1. The liquidity position is assessed:
For non-financial sector entities, this involves a detailed analysis of the adequacy of the issuer’s internal sources of funds for covering short-term uses, including working capital requirements. For companies in the financial sector, the analysis will focus on the cumulative asset-liability mismatch over the various maturity buckets and the adequacy of liquid assets to cover maturing liabilities.
2. The ratings are mapped:
While the short-term ratings are linked to the long-term ratings, the assessment in Step 1 above provides an element of flexibility in determining the exact mapping of a long-term rating into the short-term scale – that is, it is not necessarily a one-to-one mapping.
Also, the mapping for financial sector companies may be different from that of manufacturing companies as the former tends to have a better liquidity position and easier access to funds than entities in the manufacturing sector.
3. The proportion of short-term debt is determined:
This involves determining the quantum of short-term debt of the entity as a percentage of its total debt – a higher proportion of short-term debt increases the risk on a comparative basis.
Also considered here is the amount of free (unencumbered) cash flow that is available to pay short-term debt in case refinancing is not possible.
4. Availability of liquidity back-up is assessed:
Short-term debt markets are highly confidence-sensitive in nature, and investors in this market are generally unwilling to bear even a few days’ delay compared to the long-term debt markets.
A liquidity back-up facility is a mechanism that allows CP issuers to draw funds from a pre-arranged line like a revolving credit facility if they chose not to roll over the CP or are unable to do so. Liquidity back-up facilities are essential for CP programmes as they protect against the risk of default under circumstances in which investors are unwilling or unable to roll over the issuer’s CP, for example, low banking system liquidity, even though the issuer remains a good credit risk.
5. Credit-enhancement options are considered:
In addition to an issuer having a liquidity back-up mechanism, it can also have credit-enhancement options like a standby credit facility or a guarantee. This must be unconditional and irrevocable and available under all circumstances to meet the obligations should the issuer fail to do so.
6. Arrive at final short-term rating:
After the issuer’s long-term rating is mapped on to the short-term rating scale, it is adjusted up or down by a notch or two as applicable to arrive at the final short-term CP rating by considering the entity’s liquidity position, the proportion of short-term debt and free cash flow, the efficacy of a liquidity back-up facility if in place, and the impact of any credit-enhancement options that are included in the structure.
The final short-term rating arrived at should provide a basis for the cost of funding for the CP issuer, with the better rated issuers enjoying a lower effective interest rate.
A greater use of commercial paper as a short-term financing instrument should be explored in the market as there are several benefits to all involved parties including increasing the competitiveness of our regional corporates through a lower cost of debt.
Further, if successfully done, growing the CP market can lead to a further expansion and development of the Caribbean’s capital markets, a foundational requirement for financial stability and sustainable economic expansion in the region.
– Wayne Dass is CEO of Caribbean Information & Credit Rating Services Limited.wdass@caricris.com