Navigating the commercial paper market

Getting into the short-term financial world without getting burned

If you’ve ever bought a car for zero-percent financing, you can thank the commercial paper (CP) market.

CP—very short-term loans at very low interest rates—allows large companies to have immediate access to short-term financing at very low cost. Used prudently, companies can use it to efficiently make new investments for future growth. Many large industrial and consumer finance companies pass the low rates on to customers, selling everything from cars to bedroom suites through attractive “no interest for six months” financing deals.

Cheap financing has been critical to bolster performance, revenues or product sales for many companies, said finance professor Anil Shivdasani. CP provides the least expensive form of borrowing, but it must be rolled over very frequently—exposing it to risk with each rollover.

“In normal times, that strategy works very well,” Shivdasani said. “In the financial crisis, it brought some companies to the brink of collapse.”

After Lehman Brothers went bankrupt in September 2008, the reserve fund “broke the buck” on money market funds, and the CP market panicked. As financial markets began shutting down, the massive liabilities being rolled over—overnight borrowing of tens of billions of dollars for individual companies—looked like an economic avalanche of catastrophic enormity.

The list of companies potentially in jeopardy was a veritable “Who’s Who in Corporate America.” The Federal Reserve stepped in and guaranteed money market deposits, preventing a meltdown of the entire CP market.

As markets stabilized, many financial experts questioned whether companies were taking on excessive risk by borrowing so heavily in the CP market. But textbooks kept mum on the appropriate use of the CP market.

“Did companies get intoxicated by very cheap financing without appreciating the risk?” Shivdasani asked. “That’s what drove us to write this paper.”

Shivdasani collaborated with Matthias Kahl of the University of Colorado-Boulder and Yihui Wang of the Chinese University of Hong Kong to write “Why Do Firms Use Commercial Paper?”

The researchers conducted a systematic analysis of the CP market to examine how it could be used best. They documented, for the first time, how many companies use the CP market and how frequently they use it, how long companies stay in the market, the amounts companies borrow and their patterns of borrowing, how borrowing affects companies’ ability to make investments, the risks involved and how companies manage those risks.

Complicating their work was the fact that CP is the only class of unregistered securities in the U.S. Because companies do not have to file registration statements with the Securities and Exchange Commission, CP is somewhat of a shadow financial system.

Using a natural experiment, the researchers showed that CP has a causal effect on firms’ investment behavior. They constructed a comprehensive firm-level database of CP activity from the inception of CP ratings in the early 1970s. They also hand-collected a large panel data set of actual CP borrowings from 10-K filings. With this information, they examined corporate behavior around three dimensions of CP market participation: the decision to enter the CP market, the actual borrowing and the exit from the market.

What Shivdasani and his colleagues discovered about companies’ activities in the CP market made sense, given the risks and rewards inherent in the market.

The CP market is dominated by a few very large, highly creditworthy companies that can withstand the risk should the market shut down. During a financial crisis, they can refinance their obligations through other channels. Weaker companies typically don’t have those options.

“This absolutely has implications for the financial structure of these companies,” Shivdasani said. “If you want to be aggressive in the CP markets, you’ve got to have a very conservative financial profile elsewhere in your business.”

CP borrowing fell sharply after the financial crisis because companies had a newfound appreciation for the risks. Shivdasani saw a massively reduced reliance on CP markets, and many weaker companies dropped out altogether. The alternative to taking on the risk of CP, though, was to obtain financing through the regular bond markets or from banks, both of which were considerably more expensive than CP markets and limited a company’s ability to offer attractive financing rates to customers on the fence about whether to purchase the company’s products.

Shivdasani found that companies were more likely to enter the CP market when their investment needs were high and their rollover risk and cash holding were low. CP was often used as a bridge loan to long-term financing or as a substitute for cash holdings or bank credit lines. He found no evidence that the term spread influenced the decision to enter the CP market, casting doubt on market timing as a motive for CP issuance.

Rather than rely on CP for working capital, companies often used CP to fund new investment outlays until an efficient size for bond market issuance was reached. But Shivdasani’s results caution against permanently funding long-term investment with CP.

“Managers typically cite financial flexibility as a very important capital structure consideration,” Shivdasani said. “We focused on the choice of securities and the composition of debt. We found that access to the CP market—not firm characteristics—enhanced financial flexibility.”

The study holds implications for investors, too. Appreciating the risks of companies that actively engage in CP markets, investors need to understand which companies have the ability to withstand those risks. Companies that appropriately manage those risks have the liquidity to make new investments that promote growth.

Key take-aways

• Despite the massive volatility in short-term financing markets over the past few years, CP remains an attractive and viable financing source for large companies.
• Companies need to appreciate the risks of financing in short-term markets and be prepared to refinance their obligations in long-term markets to avoid the risk of financial distress.
• CP can enhance liquidity and allow companies to make new investments for future growth more efficiently, if the risks are appropriately managed.