THE U.S. CP MARKET'S "ORDERLY EXIT" MECHANISM Since 1972, the U.S. CP market has been relatively default-free when compared to its long-term counterpart. One reason for the limited number of defaults has been the orderly exit from the market of troubled CP issuers before they could fail. This has worked because investors have been relatively unreceptive to lower-quality paper. This risk aversion is particularly true in the U.S. market and is developing in other CP markets. Currently, a mere 0.8 percent of Moody's-rated CP carries a Prime-3 rating. Furthermore, very few U.S. CP investors will purchase unrated CP or CP rated Not Prime. In addition, some dealers decline to sell paper as an issuer's credit deteriorates. As a result, CP issuance often becomes uneconomical or impractical well in advance of a potential default, effectively forcing the company out of the market. Listed in Figure 14 are examples of companies that defaulted on long-term debt after exiting the CP market. (In the case of Chrysler, the date on which federal legislation providing for loan guarantees was signed into law is treated as a default date.) Also listed here is the number of days before default the issuer received a Prime-3 rating, and the number of days before default that the issuer was downgraded to Not Prime or had its rating withdrawn (WR). The Not Prime rating or withdrawal of a rating can be taken as a rough indicator of the date at which the issuer had either exited the market or was about to exit the market as current outstandings matured. Accordingly, this sample of issuers exited the CP markets an average of 1,061 days or nearly three years before defaulting on their long-term debt. Another way to consider the effect of the orderly exit process is to note the drop in outstanding paper once an issuer has been downgraded. Between 1972 and 1989, Moody's announced a total of 430 rating downgrades of CP issuers: 223 to Prime-2, 95 to Prime-3, and 112 to Not Prime. Figure 15 compares the average amount of CP (both U.S. and international) reported outstanding during the period from one to three months before a downgrade, compared with reported outstandings from three to six months after the downgrade. Downgrades to progressively lower rating categories appear to be associated with the removal of progressively larger volumes of issuers' CP from the markets, thereby reducing investors' exposure as default becomes more likely. This study brings previous Moody's studies of commercial paper (CP) defaults current through 1993 The studies were prompted in part by the dramatic increase in CP defaults beginning in 1989. From 1971, when Moody's began rating commercial paper, to 1989, CP defaults were extremely rare. Since 1989, 27 issuers have defaulted on $2.6 billion of rated and unrated publicly offered CP notes in the United States, the Euromarket, and other European domestic markets. Commercial Paper Defaults 1970-1993 Moody's Special Report THE COMMERCIAL PAPER MARKET Commercial paper is a senior level unsecured short-term note with a maturity usually ranging between one and 365 days. It is an important, flexible source of short-term financing for large corporations worldwide. CP is generally sold at a discount from par value and is placed directly by issuers or, more typically, placed indirectly through an intermediary in large denominations. Major purchasers of commercial paper include money market mutual funds, corporations, state and local governments, and commercial banks and their trust departments. Because of the large denominations and the sophistication of the institutional wholesale buyers, U.S. CP issuers are generally exempt from registration requirements. And while some trading in CP does take place in non-U.S. domestic markets, U.S. investors usually hold CP to maturity. Commercial paper is a source of liquidity for issuers and a short-term store of value for investors. It represents a flexible, low-cost alternative to bank loans, especially for the largest and most creditworthy firms. Within parameters outlined in a CP program's prospectus, issuers are generally free to float new paper relatively quickly and cheaply. Investors, on the other hand, hold funds as CP in anticipation of near-term outlays. As a rule, investors do not consider their CP holdings as risk capital. This report documents the default experience in the global CP markets since 1971, the year Moody's began rating these instruments. But background data, particularly that concerning issuers in non-U.S. markets, is often very scarce. Thus, the information presented here is, in many cases, incomplete. The U.S. Commercial Paper Market Having existed in one form or another for over two hundreds years, the U.S. commercial paper market is the largest such market in the world. It was virtually the only CP market in operation at the start of the 1980s and still accounts for roughly 60 percent of global CP outstanding. According to U.S. Federal Reserve figures, the U.S. commercial paper market totaled $548 billion at the end of 1993. However, growth in this market, as seen in Figure 1, has been virtually flat since year-end 1989. Interestingly, the last few years have seen robust growth in the volume of domestic, long-term public corporate debt. One possible explanation is that many long-term bond issuers took advantage of the decline in long-term interest rates by issuing more long-term debt than was required for expansion purposes. Flush with proceeds, these borrowers may have paid down part of their commercial paper outstandings. Following a large capital outlay, the intention may be to resume borrowing in the commercial paper market. Finance companies remain the dominant issuer in the U.S. CP market, with $392 billion outstanding at year-end 1993, versus the $156 billion issued by nonfinancial entities. Over half of the finance company CP was placed by broker-dealers. Included in the U.S. CP total is $70 billion of paper issued by non-U.S. companies. Based on Moody's rated population, as of September 30, 1993, financial issuers accounted for 51 percent of commercial paper outstanding (see Figure 2). Industrial issuers accounted for 37 percent of outstanding CP and another 11 percent was issued by structured finance entities. Figure 2 Rated Commercial Paper by Sector |