NIF’s can be best described with an example; say a issuing part agrees to an a consensus with an bank for $500 million credit facility for a period ranging from 5 – 7 years. The lead bank manages the syndication of the loan with the other banks. Any amount of funds that are withdrawn for the whole sum can be repaid at any time intervals of time. The issuer then withdraws part of the loan at an agreed rate, say LIBOR (London Inter Bank Offered Rate) +1/4 % or alternatively involves in the issue of Euro Commercial paper to a group of bankers which is lead by the NIF’s arranging bank at an agreeable rate. In this way if the ECP alternative to making a bank loan is not feasible, the banks will go on to make the loan. Thus a guarantee that funds will flow regardless of the market condition that is established.
Fig : Euronote Issuance Process , where ECP = Euro Commercial Paper , NIF = Note Issuance Facility , RUF = Revolving Underwritten Facility
The underwriting services come as a ‘packaged deal’, which marks the transformation of the arrangement of an NIF into an RUF. The underwriting services included with the NIF ensure that a borrower generally has rapid access to funds and high interest rates as well. A underwriting bank generally provides a security to the borrower with a ‘floor price’ on the notes , so that any shortfall can be offset. In turn, the bank expects an underwriting fee from the borrower for providing the required ‘insurance’ .
Similar to many other underwriting services provided by other markets, RUF’s are initiated by lead managers who assemble a tender panel of banks or placement agents. The panel purchases
the notes for distribution to various investors; sometimes hold portions of notes as well. The consensus drafted during the start of the process also mentions the share of each panel member. Any of the notes which cannot be placed are taken over by the panel members.
In contrast with the NIF, the Revolving Underwritten facility differs when different agents are used in the distributing ECP at rates which are substantially lower than bank rates. Roy(2003) states that the members of the tender panel and placement agents can bid at whatever rates they want to bid, so that it can result in a highest bid, but can be replaced by the issuer if the payments have not been satisfactory. So in turn this competitive bidding will seek to provide money market rates to the issuing party. Often these rates are lesser than the rates offered by large individual banks and they typically fall in between LIBOR and LIBID, which is called as LIMEAN, resulting in saving of 3/8% to ½%.
Issuers with very high credit ratings, rely on their own ability to sell the ECP by creating a secondary market for the same. This helps to relinquish the underwriting facility offered by the NIF’s, thereby saving on the participation and the brokerage fees charged by banks.
Commercial Paper and its Global Market
Commercial papers are short term unsecured money market instruments which has maturity dates of usually less than a year. Normally Commercial Papers are issued by large, well established corporations who have relatively higher credit ratings, which is normally rates by credit rating agencies like S&P, Moody’s etc. This is because only large corporations have lower credit default risk than others.
The advantages of CP’s are lower default risks, higher yield and a short term maturities. As most corporations sell their papers through dealers who in turn receive a commission fee; There is existence of only a primary market for CP’s as there are unique in nature thus making it difficult to trade without the involvement of the large corporation itself and mainly because of its maturity date ranging from an average of 30 days to 270 days; most corporations hold the papers until their final maturity date. Another critical advantage is that CP’s are easier to issue than a bank loan. It is important to note that commercial paper is not used for financing any fixed assets that the company wishes to invest for its growth, but rather is used for clearing any short term liquidity problems.
The basic view that a commercial paper is largely unsecured is questionable as Slovin , Sushka and Hudson(1988) have pointed out that ; Most commercial paper issues entail an element of
bank support in the form of lines of credit which provide firms with an alternate
source of corporate liquidity, since on occasion the commercial paper market may
become unavailable due to factors other than a company’s credit standing. So when in such an instance where an issuer of commercial paper is not able to pay back when the firm filed for bankruptcy, the bank steps in to provide the necessary funds. It has also been argued that shareholder wealth consequently increases, when a bank obtains backup guarantee for its CP’s.
Due to present financial crisis, the market for any unsecured financial instrument is hitting lowest figures since decades. Before the onset of the financial crisis, the total worth of the CP market was well above $2.2 million (Reuters, March 2009). The two major segments of the CP market are the unsecured financial CP sector and asset backed CP sector, which played a critical role in US housing market in the early 2007. Presently due to the badly hit US housing market, the asset backed CP market fell $4.9 billion to $712 billion (Reuters 2009). With the US federal reserve pumping taxpayer money into the US economy in an effort to unfreeze global credit markets, the CP market benefitted and picked up a notch to $8.2 billion in the US alone. (Reuters, March 2009).
RUF or Commercial Paper ?– The optimal choice.
In recent times, both the RUF and NIF have ceased to exist. The Euronote facility itself was very successful in 1980’s. It has been duly replaced by the Euro Commercial Paper program and has been very successful until the onset of the financial crisis of 2007. In practice, small business will not have any authority to sell commercial paper, unless they have a suitable credit rating. A firm in that case can only choose to obtain a bank’s line of credit and will be obliged to pay up underwriting and participation fees to the syndicate. At any point during a recession, credit rating of various companies falls, making it difficult for an organisation to sell its commercial paper. During such times, a more viable option for corporations is to seek out a syndicated loan or a short term loan, at a higher cost of interest. Sometimes the sheer volume of the big loans, makes the syndication, a complex and time consuming procedure. Nevertheless, once the formal agreements have been made, the lead bank benefits largely from the deal. At all other times, a corporation or public house must try to look towards commercial paper markets as a cost effective method of financing its short term operations.