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What is a CP back-up line of credit?

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Commercial paper usually has the highest yield of the money market instruments on the respective market due to their higher default risk relative to the other money market instruments.  Because commercial paper – other than ABCP – is unsecured, marketable commercial paper requires a liquidity line of credit in addition to a credit rating.

A back-up line of credit is a credit facility provided by one or more banks to assure investors that the issuer will have the funds required for repaying maturing commercial paper in the event it cannot be redeemed out of the issuer’s operational cash flow or the market proves inaccessible for rolling it over.  The risk that the issuer will not be able to pay off maturing commercial paper with the proceeds of new CP is rollover risk.

Rating agencies require evidence of short-term liquidity. The highest-rated CP issuers can maintain liquidity back-up of as little as 50% of the outstanding paper, while firms with a lower investment grade rating generally have to maintain 100% backup.  CP with the highest ratings is most widely accepted by investors, although lower rated or even unrated paper is also sold.

Banks commonly charge a commitment fee of ½%-1% for providing the liquidity line of credit, which increases the effective cost of issuing paper.  Despite the fee, CP issuers can usually raise funds through such credit-supported commercial paper at a lower cost than by borrowing from banks.

Because CP issues of US banks are treated as deposits and, thus, are subject to reserve requirements and Federal Deposit Insurance Corporation (FDIC) fees, the US CP market is little used by the banks for their funding.  However, as sponsor and by means of ABCP, banks can provide their clients corporate funding through the CP market.

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