LIQUIDITY and CP

When a governmental entity knows that its tax money will be received within the next few months but needs cash flow for operations now it often issues tax anticipation notes. The cash from the sale of these short-term notes gives the government liquidity until taxes are received. In the same way, corporations often need funds to complete the manufacturing process on goods that will produce revenue later. The corporation can use bank loans but with good credit they turn to the money markets for a short-term loan in the form of commercial paper (known as CP).

Commercial paper was created in the early 19^th century and was used primarily by manufacturing firms for the first 100 years. In the 1920’s the market changed with autos and consumer items financed through finance companies. Then with tight monetary policy in the 1960’s financial institutions also entered the market through their holding companies.

Initially commercial paper was not rated, but after the 1930s, when some defaults occurred, the market changed from many issuers to a major few. Now the majority of paper is rated.

The rating agencies
look at management
of the corporation,

A1/P1

earnings and the balance sheet but they focus on liquidity because most paper is issued and "rolled" into new issues by the issuer. For this reason the rating agencies and investors use rate tiering which looks at both the short and long-term rates of the corporation.

Under the Public Funds Investment Act, authorized commercial paper must be rated not less than A1/P1 by two nationally recognized rating agencies (or one agency and a letter of credit). The paper must be under 270 days. Most CP is sold in the 1-3 month's maturities however.

Because there is some credit exposure in CP, the investor can expect additional yield over the more liquid and credit worthy treasury bills. The amount of this difference is dependent on money and economic conditions. As in most short-term investing, the keys to utilizing this market safely are to monitor the credit exposure, diversify the issuers purchased and diversify within the portfolio itself. These safeguards allow the investor to access the market and enjoy the yield benefit without adding risk.