September 10, 2008

Commercial Paper - A Primer

A Short Guide to Commercial Paper and the S&P U.S. Commercial Paper Index
Commercial Paper is a money-market instrument generally issued by
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large banks and corporations to finance working capital and other short-term needs. The current size of the U.S. Commercial Paper market is over

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US$ 1.7 trillion. Commercial Paper generally offers very low risk but higher yields than other short-term assets. Commercial Paper has returns that have low correlations with stocks and bonds, making them good for portfolio diversification. Risk factors include default risk, rollover risk and liquidity risk. The S&P U.S. Commercial Paper Index is designed to serve the investment communitys need for a benchmark representing the U.S. Commercial Paper market. The index consists of issues from large corporate issuers of commercial paper and with maturities of one to three months.

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Commercial Paper Primer

September 10, 2008

Introduction to Commercial Paper

What is Commercial Paper Commercial Paper is a short-term, unsecured promissory note issued in the open market representing the obligation of the issuer. Issues typically have maturities of less than 270 days with maturity most commonly in the 30 day to 50 day range. Commercial paper is usually offered at a discount reflecting current market interest rates. The commercial paper market represents a large and important part of the fixed income market. In some years the size of the U.S. Commercial Paper market has exceeded that of the U.S. treasury market. Why do companies issue commercial paper? Commercial paper provides an alternative to bank borrowing for large corporations with strong credit ratings. The cost of borrowing by issuing commercial paper is generally cheaper and less restrictive than borrowing from a bank. Commercial Paper is often used to provide short-term funds for seasonal and working capital needs. It is also used as bridge financing to provide funds until long-term financing is acquired. Issues with less than 270 days to maturity are exempt from SEC registration thus saving the issuer the costs associated with registration. The largest issuers are generally financial firms and captive finance companies.

What are the different kinds of commercial paper? The commercial paper market is generally divided into corporate issued commercial paper and asset backed commercial paper. Corporate issued commercial paper is unsecured debt representing an obligation of the issuing entity. Corporate issuers of commercial paper are often divided into financial and non-financial companies. Asset-backed commercial paper is issued by a special purpose vehicle or conduit that generally uses the proceeds of issuance to obtain interests in various types of assets. The Federal Reserve Board publishes yield and outstanding amount information on the financial, non-financial and asset backed portions of the commercial paper market. There is also a large market for Municipal Commercial Paper. This primer focuses on the corporate and asset-backed markets.

Who generally invests in commercial paper? Money market funds are the largest holders of commercial paper, accounting for roughly 1/3 of all outstanding paper. Other common investors include retirement and pension funds, corporate treasuries, life insurance companies and households.

Can individual investors invest in commercial paper? Commercial paper is generally issued in $100,000 denominations. Thus smaller investors can only invest in commercial paper indirectly, such as through money market funds. Smaller investors may also have exposure to commercial paper through retirement and pension funds.
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Commercial Paper Primer

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What are the advantages of investing in Commercial Paper? Low risk - There have been very few cases of companies defaulting on commercial paper over the last thirty years. Most issues are of a very short-term nature making it easier to assess the ability of the issuer to meet the obligation than for longer-term debt. Also, most issuers are large companies with strong credit. Moodys has reported default data on commercial paper from the period 1972 -2004 showing that issues rated P-1 or P-2 (the vast majority of rated issues) have both had a 0% default rate over a 30 day horizon and default rates over a 365 day horizon of only .02% and .11%, respectively. Limited Reinvestment Risk The short time horizon of commercial paper limits the risk of large interest rate fluctuations. Yield - Commercial paper tends to have a higher yield than other similar short-term assets, such as treasuries and certificates of deposit.

What are the risks of investing in Commercial Paper? Credit Risk - While extremely rare for corporate issuers the chance of an issuer defaulting on commercial paper does exist. Interest Rate Risk - Commercial paper prices are susceptible to changes in market interest rates. However, due to its relatively short maturities commercial paper generally has less interest rate risk than other, longer-term fixed income securities. Also, most investors in commercial paper hold the paper until maturity. The return on commercial paper held until maturity is not affected by price movements. Rollover Risk Commercial paper is generally paid rolling-over into new short-term paper. An investor faces the risk that the issuer will be unable to issue new paper at maturity. To eliminate this risk, commercial paper issuers will often back commercial paper with an unused bank credit line. This increases the cost of issuance. Liquidity Risk If the there is a rapid change in sentiment among investors, whether due to issues specifically concerning the commercial paper market or issues in the financial market as a whole, the commercial paper market could face problems of illiquidity. For instance while average rates on A2 non-financial commercial paper, as computed by the Federal Reserve Board, were relatively steady between 2.7% and 3.0% from May 1, 2008 through Sep. 15, 2008, they jumped to 5.02% on Sep. 17 and 6.02% on Sep. 18 as liquidity in the market dried up.

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Commercial Paper Primer

September 10, 2008

What is the return and volatility profile? Exhibit 1: Historical Risk/Return Profile for Commercial Paper, Stocks and Bonds
Commercial Paper 3.82% 0.52%

Annualized Returns Annualized Volatility Correlation with .109 .017 Commercial Paper Sources: Standard & Poors, Lehman Brothers and Federal Reserve Board. Figures are from December 31, 1997 through August 31, 2008. Common stocks refer to the S&P 500, bonds refer to the Lehman Brothers U.S. Aggregate and Commercial Paper is calculated based on yields on one-month financial and non-financial commercial paper published by the Federal Reserve Board with an 80% weight given to financials and a 20% weight given to non-financials. These weights are reflective of current market conditions and similar to current weights for the S&P U.S. Commercial Pape Index. Defaults are not taken into account for this calculation.

Bonds 5.79% 3.42%

Common Stocks 4.34% 14.77%

What are typical yields for commercial paper? Yields on commercial paper generally move in line with short-term interest rates. Yields on commercial paper tend to be slightly higher than those on treasury bills, reflecting the additional minor credit risk associated with commercial paper. Exhibit 4: Yield on Corporate Commercial Paper Versus 1 Month US Treasury Bill
7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 12/1999

12/2001

12/2003

12/2005
1 Month Treasury Bill

12/2007

Commercial Paper

Sources: Standard & Poors, Federal Reserve Board, Bloomberg. Commercial Paper yield calculated as a weighted average of financial and non-financial commercial paper yields as reported by the Federal Reserve Board, with an 80% weight in financials and a 20% weight in non-financials.

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Commercial Paper Primer

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How big is the Commercial Paper market? As of August 2008 the total outstanding amount of commercial paper in the United States was over US$ 1.78 trillion. The market has grown from US$ 113 billion in 1979. Exhibit 2: Size of Commercial Paper Market
2500

2000

$ Billions

1500

1000

500

0 1992 1995 1998 2001 2004 2007

Year

Source: Federal Reserve Board

What is the breakdown of the Commercial Paper market by type of issuer? Exhibit 3: Breakdown of Commercial Paper Market by Corporate and Asset Backed Issues
100%

80%

60%

40%

20%

0% 1998 2001 2004 2007

Corporate

Asset Backed

Source: Federal Reserve Board

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Commercial Paper Primer

September 10, 2008

How would a Commercial Paper Index Fund compare to other short-term investments?
Commercial Paper Index Fund Principal Risk Small principal risk Broadly diversified among over 1000 securities Excluded 2.42% Money Market Mutual Fund Small principal risk Typically diversified over a couple hundred issues May be included 2.22% Certificate of Deposit Investments up to $100,000 are insured by FDIC. Amounts above that risk bank default. No diversification

Diversification Exposure to assetbacked vehicles (conduits, SPVs, etc) Current Yield

Not applicable 2.46%

Source: Standard & Poors. Yield for money market mutual funds is from the Crane 100 Money Fund Index 30-Day Yield. Yield for Certificates of Deposit is the average one-month CD rate as published by the Federal Reserve Board. Yield for commercial paper is the S&P U.S. Commercial Paper Index less an estimated expense ratio of .20%.

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Commercial Paper Primer

September 10, 2008

The S&P U.S. Commercial Paper Index

What is the S&P U.S. Commercial Paper Index? The S&P U.S. Commercial Paper Index is a broad based commercial paper index consisting of commercial paper issued in the United States ranging from one-month to three-month maturity. What types of Commercial Paper are included in the index? The S&P U.S. Commercial Paper Index includes commercial paper issued by corporate issuers, both financial and non-financial. Asset-backed commercial paper issues are excluded from the index. How are constituents selected for the index? All commercial paper issues that meet the following eligibility criteria are included, subject to the constraint that no single issuer may be represented in the index by more than ten issues: The issuer must be a corporate issuer. This includes publicly traded and privately held corporations as well as subsidiaries of corporations. Asset-backed issuers are not eligible. The issuer must have a maximum program size of at least $2 billion as of the most recent semi-annual review. The commercial paper program of each issuer must have a current rating from at least one of Standard & Poors, Moodys or Fitch. The security must have between 31 and 91 days to mature as of the rebalance date.

How are constituents weighted in the index? Constituents are weighted in the index based on the maximum program size of the issuer based on the following: Maximum Program Size US$ 2 billion size < US$ 5 billion US$ 5 billion size < US$ 15 billion size US$ 15 billion Weight Factor 1 2 3

Thus, an issue from an issuer with a maximum program size of $20 Billion will have a weight in the index triple to that of an issue from an issuer with a maximum program size of $4 Billion.

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Commercial Paper Primer

September 10, 2008

How many constituents are there in the index? The index does not have a set number of constituents. Rather, the number of constituents floats based on how many issues are eligible at each rebalancing. As of September 5, 2008 the index had 1109 constituents.

What is the current yield of the index? Exhibit 5: Yield on Commercial Paper Versus Other Asset Classes

6% 4.99% 5% 4% 3% 2% 1% 0% Treasury Bills Money Market Certificates of Commercial Mutual Funds Deposit Paper Bonds 1.57% 2.22% 2.46% 2.62%

Sources: Standard & Poors, Lehman Brothers, BankRate.com, Bloomberg. Yield for Treasury bills is the one-month U.S. Treasury Bill. Yield for money market mutual funds is from the Crane 100 Money Fund Index 30-Day Yield. Yield for Certificates of Deposit is the average one-month CD rate as published by the Federal Reserve Board. Yield for commercial paper is the S&P U.S. Commercial Paper Index. Yield for bonds is the Lehman U.S. Aggregate Index. Data as of September 5, 2008. Data for money market mutual funds is from July 31, 2008.

How often are constituents added and removed from the index? The index is rebalanced on a monthly basis at the end of each month. The list of eligible issuers for the index is determined on a semi-annual basis at the end of June and end of December rebalancings. The complete methodology is available on the web at www.indices.standardandpoors.com. What are the ticker symbols for the index?
Index S&P U.S. Commercial Paper Index Bloomberg SPBDCP Reuters .SPBDCP

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Commercial Paper Primer

September 10, 2008

Disclaimers
This report is published by Standard & Poors, 55 Water Street, New York, NY 10041. Copyright 2008. Standard & Poors (S&P) is a division of The McGraw-Hill Companies, Inc. All rights reserved. Standard & Poors does not undertake to advise of changes in the information in this document. "Standard & Poor's" and "S&P" are trademarks of The McGraw-Hill Companies, Inc. Other index names are trademarks of respective index providers. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. Standard & Poors makes no representation with respect to the accuracy or completeness of these materials, whose content may change without notice. Standard & Poors disclaims any and all liability relating to these materials, and makes no express or implied representations or warranties concerning the statements made in, or omissions from, these materials. No portion of this publication may be reproduced in any format or by any means including electronically or mechanically, by photocopying, recording or by any information storage or retrieval system, or by any other form or manner whatsoever, without the prior written consent of Standard & Poors. Standard & Poors does not guarantee the accuracy and/or completeness of the S&P U.S. Commercial Paper Index, any data included therein, or any data from which it is based, and Standard & Poors shall have no liability for any errors, omissions, or interruptions therein. Standard & Poors makes no warranty, express or implied, as to results to be obtained from the use of the S&P U.S. Commercial Paper Index. Standard & Poors makes no express or implied warranties, and expressly disclaims all warranties of merchantability or fitness for a particular purpose or use with respect to the S&P U.S. Commercial Paper Index or any data included therein. Without limiting any of the foregoing, in no event shall Standard & Poors have any liability for any special, punitive, indirect, or consequential damages (including lost profits), even if notified of the possibility of such damages. Standard & Poors does not sponsor, endorse, sell, or promote any investment fund or other vehicle that is offered by third parties and that seeks to provide an investment return based on the returns of the S&P U.S. Commercial Paper Index. A decision to invest in any such investment fund or other vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or vehicle. Analytic services and products provided by Standard & Poors are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poors has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

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