What Is Commercial Paper?

Commercial paper is a type of debt issued by a company that can serve as a source of funding for its operations. Money raised from commercial paper can be used to meet short-term needs, such as payroll, inventory finance, or payment for raw materials. Companies often prefer commercial paper to bank loans, which tend to carry higher interest rates.

Commercial paper is a type of unsecured debt, which means it isn’t backed by assets or other types of collateral. Instead, issuers have lines of credit from banks to back the debt. Just as a person’s eligibility for a credit card is based on their credit score, a company’s ability to issue commercial paper is based on its creditworthiness.

In the commercial paper market, the company issuing the debt is usually perceived to be low risk. Still, ratings agencies such as Moody’s and Fitch issue credit ratings on the commercial paper to be sold as a measure of potential investment for prospective buyers. The typical issuer of commercial paper is a large corporation with a strong credit rating.

How Long Does Commercial Paper Take to Mature?

Commercial paper can have a maturity as short as overnight or as long as 270 days. The duration is significant because any debt with a maturity exceeding 270 days must be registered with the Securities and Exchange Commission (SEC). So, a company issuing millions of dollars in commercial paper doesn’t have to face the scrutiny of the SEC if their debt matures in 270 days or fewer. Since commercial paper has a duration of less than a year, it is recognized as a liquid asset.

The average duration of a commercial paper is 30 days, according to the Federal Reserve. That being said, it is common for companies to roll over their commercial paper when they are due by issuing new paper.

A Brief History of Commercial Paper

Commercial paper reportedly originated in the U.S. in the 1700s, and its widespread use as a debt facility gained traction in the 1800s when businesses—typically requiring funds for inventory—started issuing promissory notes on paper.

Investment banking giant Goldman Sachs traces its origin and prominence in the commercial paper market to founder Marcus Goldman, who first sold promissory notes in 1869. He built up relations with small business owners such as wholesale jewelers and leather merchants in Lower Manhattan and helped them issue commercial paper based on their creditworthiness.

In the first year of operations, as an intermediary between borrowers and institutional lenders, he led transactions totaling $5 million (the equivalent of $111 million in 2023). In the 1970s, Goldman Sachs was the biggest dealer in the U.S. commercial paper market.

While commercial paper is largely unsecured debt, some corporations use assets—such as receivables—as collateral, and this is known as asset-backed commercial paper (ABCP). It typically has maturity durations of 90 to 180 days. Transactions of ABCPs picked up in the 1990s, and these helped to push the value of the U.S. commercial paper market up to a record $2.2 trillion in July 2007.

Transactions for ABCPs declined during the financial crisis of 2007–2008 because ABCPs were used to fund longer-term asset-backed securities, of which their credit ratings were questionable, and issuers had difficulty rolling over their debt as the market for those securities collapsed. The Federal Reserve Board temporarily set up a commercial paper funding facility (CPFF) on October 27, 2008, to address liquidity concerns by buying commercial paper.

Fed data showed that the outstanding value of U.S. commercial paper exceeded $1.25 trillion at the end of 2022. (In comparison, the total value of the U.S. debt market was about $30 trillion.) Still, the commercial paper market is up from about $951 million in late 2020, during the height of the COVID-19 pandemic. The Fed for the second time opened up the CPFF on March 17, 2020, for the purchase of commercial paper during the pandemic. This was a way to keep money flowing into the economy by allowing companies that might be distressed to raise funds. The CPFF stopped buying commercial paper a year later.

Who Are the Important Participants in the Commercial Paper Market?

There are generally three major players in the commercial paper market: those who issue, those who purchase, and those who deal.

Issuers

These are corporations and financial institutions. Typically, the bulk of commercial paper issuance comes from banks and finance companies that are raising funds. Sovereign governments also sell commercial paper from time to time.

Buyers

Investors include mutual funds, foreign corporations, pension funds, and state and local governments that seek to diversify their holdings.

Dealers

Typically, the biggest investment banks and securities firms deal the commercial paper because they have clients who both sides of the transaction: buyers and sellers. There is no official list of commercial paper dealers as there is for primary dealers of government debt. When the Fed set up the CPFF, most of the commercial dealers listed were also primary dealers.

How Is Commercial Paper Issued, Sold, Purchased & Redeemed?

A company seeking to sell commercial paper does so through a dealer that serves as an intermediary between it and the dealer’s clients, the buyers. For example, an automobile manufacturer wants to raise $50 million to pay bonuses to management on what is expected to be a record quarter in sales. It can’t get money quick enough, so the automaker turns to commercial paper for immediate funding and wants to pay the face value of the paper in 90 days. A dealer works with the issuer to set the discount rate and finds buyers. Investors buy the commercial paper but must wait 90 days to receive their money back, with interest.

The dealer makes money from the transaction by buying the commercial paper from the debtor and selling it at a higher price to investors, pocketing the difference. Thus, commercial paper rates tend to be a bit higher than Treasuries with similar maturities to account for the dealer’s profit.

Commercial paper works like fixed-income investments but tends to have rates higher than Treasuries with similar maturities, and even higher than bank savings deposit rates.

How Are Interest Rates on Commercial Paper Calculated?

When a company issues commercial paper that is due, for example, in 270 days, the company agrees to pay back the face value at the end of 270 days. It sells the commercial paper at a discount, or below par value, and it buys the paper back at face value. The difference is the interest earned by the investor (and the price paid by the issuer for the temporary use of the buyer’s funds).

What Are the Differences in Commercial Paper Internationally?

The U.S. has the biggest market in commercial paper, and is designated abroad as U.S. commercial paper (USCP). While other countries may have their own commercial paper market, commercial paper issued internationally is known as Eurocommercial paper (ECP), but the debt can be in any currency denomination. The other big markets for commercial paper are in Canada and the U.K.

Eurocommercial doesn't face the scrutiny of the SEC and isn’t limited by the 270-day maturity duration that would trigger oversight. Typically, the length of maturity for Eurocommercial paper can be as long as 364 days, or less than a year.

Frequently Asked Questions (FAQ)

The following are answers to some of the most common questions investors ask about commercial paper.

What Are the Differences Between Commercial Paper and Bonds?

Unlike bonds, which can be redeemed at any time, investors in commercial paper must wait to be paid out at maturity. Like most types of bonds, taxes must be paid on any interest earned.

Who Are the Biggest Issuers of Commercial Paper?

Banks and finance companies are among the biggest issuers of commercial paper.

Who Are the Biggest Holders of Commercial Paper?

Money market mutual funds, corporations, and state and local governments are among the biggest holders of commercial paper.

What Is Asset-Backed Commercial Paper?

Some companies use assets as collateral for their commercial paper offerings, and this is known as asset-backed commercial paper. Its maturity durations are typically 90 to 180 days.

What Is Credit-Supported Commercial Paper?

Credit-supported commercial paper is typically backed by a bank, which agrees to pay the face value of the debt if the issuer does not. 

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On March 22, the U.S. Federal Reserve (Fed) hiked interest rates by 25 basis points to curb inflation despite turmoil in the banking industry, noting that “the U.S. banking system is sound and resilient,” but “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”

While the full impact of the turmoil in the banking industry and the Fed’s response is still unknowable, we are gaining perspective on its economic impact, and thus its investment implications. Captured below are perspectives from each of our investment teams.

Macro Environment

Since the beginning of March, U.S. policymakers have taken aggressive steps to alleviate liquidity stress in the U.S. banking system. For as long as the yield curve remains inverted, concerns about some banks—particularly smaller, regional ones—may persist.

As these smaller financial institutions play a critical role in the U.S. economy, continued liquidity challenges in the banking sector may dampen banks’ appetite and ability to lend, thereby curtailing some economic activity. Smaller banks—those with assets of less than $250 billion—account for 60% of residential and 80% of commercial real estate lending. All in all, smaller U.S. banks extend about 50% of all commercial and industrial (C&I) loans and 45% of consumer lending.

The Fed provides weekly data on various types of bank lending with a 10-day lag. We note that lending by small banks has decelerated already—presumably in response to the stress in the banking system. Whatever the reason, softer bank lending effectively amplifies the already dampening effect of higher rates on economic activity. In this sense, banking system stress may obliviate the need for additional rate increases.

While we remain of the view that the Fed will prefer to raise rates and then pause for a considerable period of time, liquidity challenges in the banking sector may effectively lower the federal funds rate setting necessary to cool domestic demand enough to cool consumer price inflation to 2% to 3% by 2024 year-end.

U.S. Value Equity

It’s shocking to think that the KBW Bank Stock Index (BKX) has fallen by nearly 30% in the month of March. However, when bank failures occur, it’s not uncommon for investors to sell shares and ask questions later. Even prior to the Silicon Valley Bank (SVB) Financial debacle, we had been actively reducing our exposure to the banking subsector and are net underweight relative to our respective indices. Why? As fundamental investors, it’s important to remember the factors we believe drive bank stocks over the longer term: net interest margins, loan growth, and credit quality.

Net interest margins: We believe we are closer to the end of this rate-hiking cycle than the beginning. It’s generally believed, however, that the stress of the last several weeks will help further the disinflation narrative, and some investors are now predicting rate cuts for the back half of 2023. We, however, continue to believe inflation, while moderating, will take time to return back to the Fed’s 2% target. If the Fed is forced to hold rates higher for longer than the market is pricing, pressure on net interest margins will likely continue as banks have to keep paying up to retain deposits. As such, we believe the expansion in net interest margins that regional banks have enjoyed over the last several years is likely not to continue. 

Loan growth: We estimate that between the start of the pandemic and when the Fed began raising interest rates last year, deposits at U.S. banks rose by more than $5 trillion. However, due to weak loan demand, less than $1 trillion was lent out. We have yet to see how much of those deposits have now left smaller regional banks to either higher-yielding alternatives (such as money markets) or the safety of systemically important financial institutions (SIFIs). Regardless, it’s hard to imagine an environment in which loan growth can catch up with deposits in the near term, especially if we are entering a potential recession in which banks will tighten their lending standards.      

Credit quality: Historically, bank failures have occurred due to credit issues as opposed to a mismatch of duration between assets (long-term government debt) and liabilities (deposits). We find it intriguing that some (admittedly poorly managed) banks have failed due to their inability to hedge their interest-rate exposure properly in a rising-rate environment. It makes one ask if credit will be the next shoe to drop. It’s quite plausible to expect that banks will react to this turmoil by tightening their own lending standards. This, in turn, could cut off access to credit for individuals and businesses seeking to borrow, increasing the chance of a recession and likely credit issues. We are already starting to see the cracks of such, whether in venture-backed technology, the California wine industry, or the commercial real estate sector, where smaller banks have grown their exposure compared to their larger peers in recent years.

Longer term, we believe regional banks that have been prudently managing their balance sheets with diversified deposit bases will likely benefit. 

Given the magnitude and speed of recent events, it will take time to truly understand the far-reaching implications. It’s likely the banking industry will now face much tougher regulation, a higher risk of increased capital requirements, higher fees to cover the likelihood of FDIC insurance increases, and a renewed debate about which institutions are too big to fail.

For these reasons, along with the factors referenced above, we remain cautious about increasing our weighting to banks in the current environment. However, the recent volatility does offer the opportunity to upgrade the quality of our holdings. Given the sell-off, valuations for some banks are beginning to look attractively priced, even when we stress their tangible book value for unrealized losses in their held-to-maturity portfolios.  

Longer term, we believe there will continue to be a place for regional banks within the banking system, and that those that have been prudently managing their balance sheets with diversified deposit bases will likely benefit. 

As we shift through the rubble looking for high-quality franchises that have been indiscriminately punished, we will continue to prudently manage the portfolios and alert you to our thinking about portfolio positioning. 

U.S. Growth and Core Equity

While the issues that resulted in SVB Financial’s failure were largely driven by the unique nature of the company’s asset and deposit base, the economic and stock market implications are potentially much broader. All banks have a fundamental mismatch between the duration of their assets and liabilities, and their revenues and costs can respond differently to changes in interest rates. This mismatch can come with significant consequences when confidence in the banking system falters, as we are seeing today. As individuals and businesses pull deposits from banks they view to be less safe and put those deposits into larger banks, you could see additional bank failures and/or sustained higher market share at larger banks at the expense of smaller regional players.

We are actively assessing our U.S. growth and core portfolio companies against a widened range of potential outcomes as this situation unfolds.

At a higher level, the funding costs for banks are likely to increase given pressure on deposit flows and the higher cost of those deposits. Higher funding costs and a preference to build excess capital on their balance sheets could lead banks to tighten lending standards. This in turn would reduce the availability and increase the cost of financing for businesses broadly and for the consumer. It is too early to know, but the lagged impact of the Fed’s tightening cycle and potentially more restrictive bank lending standards may lead to slower economic growth ahead.

Following an era of inexpensive capital for the last 10-plus years, an environment of higher interest rates and higher inflation could result in a more challenging operating environment for businesses and a more discerning market environment. Companies with strong balance sheets, durable business models, sustainable cash flow, and the ability to self-fund growth are uniquely positioned in this type of environment and over the long term. While we remain focused on investing in mispriced, durable business franchises, we are actively assessing our portfolio companies against a widened range of potential outcomes as this situation unfolds.

Global Equity

UBS’s acquisition of Credit Suisse last weekend marked what was essentially the fourth major bank failure in recent weeks. The combined failure of these four banks prompted an in-depth analysis of the global banking landscape.

We believe Credit Suisse is a fundamentally impaired business after years of instability and losses. Moreover, comments from a key shareholder (Saudi National Bank) and heightened volatility in the global banking sector impaired confidence in the bank. The UBS deal is a best-case outcome to prevent contagion and systemic risk to the financial system because Credit Suisse is a global systemically important bank (GSIB).

The biggest surprise was the full writedown of Credit Suisse’s additional tier-one (AT1) bonds, but not its common equity, which would usually receive priority over equity in a bank failure. The fact that this did not occur in the Credit Suisse/UBS deal led AT1s to trade down until other regulators outside of the Swiss clarified their own stance where AT1s fall in the capital stack, partly alleviating market concerns. Although funding costs may rise, we do not believe this will cause concerns about capital more broadly at this point.

Across developed and emerging markets, we tend to invest in higher-quality banks, which generally have held up well through the current situation.

Additionally, some indicators that we watch for signs of financial market stress—such as spreads in wholesale U.S. dollar funding markets and credit index default swap (CDX) levels—started to subside this week from elevated levels the prior week.

Broadly speaking, we believe developed market ex-U.S. banks’ balance sheets are generally sound. The market structure is more consolidated than it is in the United States, with the largest five or six banks having the majority of market share. Developed market banks are also heavily regulated and stress-tested, and key liquidity and capital ratios are at healthy levels. That said, as interest rates rise and the economic environment deteriorates, banks in developed markets will likely see loan growth slow, the benefits of higher interest rates ease, competition for deposits increase funding costs, and asset quality deteriorate. Although balance sheets are generally solid, the environment will likely result in lower growth and returns.

Similar to developed market banks, emerging markets (EM) banks generally have sound balance sheets, but we look at them on a case-by-case basis because their market structures and risks tend to be idiosyncratic.

Across developed and emerging markets, we tend to invest in higher-quality banks—those with strong competitive advantage, high return on equity (ROE), and healthy capital ratios—which have proven their ability to deliver through credit cycles. Generally, these banks have held up well through the current situation. Contagion is, of course, a concern, and the situation is highly fluid, so we are constantly reevaluating the situation to ensure we are comfortable with our investments across financials as the situation evolves.

Emerging Markets Debt

EM fixed income is not directly exposed to problems in the U.S. financial sector, but high-yield EM debt has been significantly impacted by increased risk aversion. Forced selling from exchange-traded and other passive funds amid very poor liquidity conditions exacerbated the sell-off.

That said, we believe EM fundamentals remain resilient and that current prices provide a very attractive investment opportunity.

We have been gradually increasing exposure to high-yield EM credit and local currency debt.

EM banking systems look better positioned in terms of capital than they were during the Global Financial Crisis, thanks to the implementation of robust macroprudential regulation in recent years. While there are a few countries where the banking system displays certain vulnerabilities, very few of them have broad challenges that would create near-term solvency and financial-stability concerns.

We believe recent developments in the global banking sector will impact EM banks mostly through second-order effects, as direct links to affected institutions are limited. Most EM bank debt issuers are leading local institutions and benefit from granular and well-diversified deposit bases, which support robust liquidity profiles.  

Overall, EM credit spreads, yields, and currency valuations are at historically attractive levels.  Moreover, concerns about the U.S. financial sector should bring forward the end of the monetary tightening cycle, in our opinion.

All things considered, our positive medium-term view for EMD remains intact, and we have been gradually increasing exposure to high-yield EM credit and local currency debt.

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The post Banking Turmoil: Outlook and Investment Implications appeared first on William Blair.

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If You’re Worried About Banks, Invest Here Instead

During the current period of intense market volatility, some investors have grown fearful. For these concerned investors, municipal bonds, aka “munis,” are worth a look. Munis are issued by state and local governments, and generally pay tax-exempt interest at the federal and potentially state levels.

Municipal bonds have played a vital role in building the framework of America’s modern infrastructure, and were a major source of financing for canals, roads, and railroads during the country’s westward expansion in the 1800s.

Today, the proceeds from municipal debt continue to fund a wide range of state and local infrastructure projects, including schools, hospitals, universities, airports, bridges, and highways, as well as water and sewer systems.

Here’s all you need to know, and how to buy them…

Munis 101

Municipal bonds are often thought of as tax-exempt vehicles that are appropriate only for investors who fall into higher tax brackets. However, municipal bonds can offer potential advantages to investors of all income brackets.

In general, municipal bonds fall into one of two categories: general obligation and revenue. The main difference between the two is the source of revenue that secures their principal and interest payments. Here are the specifics from the Invesco Primer on municipal bonds…

General obligation bonds are secured at the state level by the state government’s pledge to use all legally available resources to repay the bond. At the local level, general obligation bonds are backed by an ad valorem tax pledge that can be either “limited” or “unlimited.” The agreed-upon definitions of these terms that appear in ordinances across municipalities are:

•  Limited tax: Secured by a pledge to levy taxes annually “within the constitutional and statutory limitations provided by law”
• Unlimited tax: Secured by a pledge to levy taxes annually “without limitation as to rate or amount” to ensure sufficient revenues for debt service

Other than states, issuers of general obligation bonds include cities, counties, and school districts.

Revenue bonds are secured by a specific source of revenue earmarked for repayment of the revenue bond.

• Enterprise revenue bonds are typically issued by water and sewer authorities, electric utilities, airports, toll roads, hospitals, universities, and other not-for-profit entities.
• Tax revenue bonds are backed by dedicated tax streams, such as sales taxes, utility taxes, or excise taxes.

Muni bonds come with a large tax break for taxpayers. Without this, there are few reasons to hold them. How much is the tax break worth? As Invesco explains in their basic Muni primer, to work out the Tax Equivalent Yield (TEY) you have to do a bit of math:

Given that different investors pay different marginal rates of tax federal income tax, the tax equivalent yields that you receive from the same bond will be different. In simple terms, the higher your marginal tax rate, the higher your TEY.

There are several reasons why looking into the $4 trillion municipal bond market may make sense now.

Why Buy Munis?

One reason munis make sense for many investors is that many issuers have a monopoly over their services and don’t face competition like corporations do.

An even better reason is that issuers are often backed by durable revenue sources such as taxes. As a result, defaults tend to be rare, even during recessionary periods. For example, during the financial crisis of 2007–2009, only 12 rated issuers defaulted, compared with 414 corporate bonds of similar credit quality.

Currently, many muni issuers are financially strong. That’s due to substantial pandemic-related support from the federal government as well as recently surging tax revenues as the economy has recovered from the pandemic.

In fact, the balances of rainy-day funds—money states set aside to use during unexpected deficits—are at near-record levels. Even Illinois, the lowest-rated state in the muni market had a rainy-day fund balance of more than $600 million in 2022, compared with just $4.15 million in 2020.

Also keep in mind that, in general, muni bonds have strong credit ratings—usually higher than corporate bones. Nearly 70% of the Bloomberg Municipal Bond Index is rated in the two highest categories, compared with just 8% of those in the Bloomberg Corporate Bond Index.

And then, of course, we come to yields.

Raymond James’s Municipal Bond Investor Weekly shows that the yield on 10-year Single-A-rated Munis trades below U.S. Treasuries, but the Tax Equivalent Yield of 10-year Single-A-rated Muni trades at the equivalent U.S. Treasury yield plus 126 basis points.

Here is some of the commentary from the March 20 issue of Municipal Bond Investor Weekly:

All this [market] uncertainty has caused a flight to quality as investors shift out of risky assets and into bonds. As investors pour into high quality bonds, municipal bond prices have rallied sending yields lower. 10-year muni yields are ~25 basis points lower, but this pales in comparison to Treasury yields which are ~53 basis points lower from March 7-17, 2023. Longer maturities followed a similar path with 20-year muni yields lower by 16 basis points compared to Treasuries, down 32 basis points.…Taking a longer view, 10 and 20-year maturity municipal bond yields are at or close to their historical highs not seen since 2018. The past year has been marked with volatility and, while off their recent highs, 20-year muni yields are approximately 100 basis points higher than a year ago and 10-year yields are approximately 30 basis points higher.

How to Buy Munis

Your best bet may be to buy individual munis tailored to your specific financial situation. All the major brokerages have bond specialists that can do this for you.

However, there are municipal bond mutual funds and ETFs that you can buy online in your brokerage account. Here are a few examples…

The largest muni bond ETF is the iShares National Muni Bond ETF (MUB). It is up about 1% year-to-date and has a 30-day SEC yield of 3.15%. The expense ratio is a tiny 0.07%.

There are also closed-end funds that focus on munis—and often on specific states and that often have a higher yield.

The largest national muni closed end fund is the Nuveen Municipal Value Fund (NUV). It is up about 0.50% year-to-date and has a distribution rate of 3.85%. However, its expense ratio is higher at 0.50%.

The biggest of such funds focused on a single state is the Nuveen California Quality Municipal Income Fund (NAC). Many of the larger states have a closed fund dedicated to them, so make sure to check on the internet for a list.

If You’re Worried About Banks, Invest Here Instead
Tony Daltorio

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