PRACTICE ESSENTIALS® INDEXING 101 | U.S. Indexing Commercial Paper CONTRIBUTOR Introduction Tyler Cling For over a century, a key component of the money market has been the short-term Senior Manager promissory note, also known as commercial paper. Typically unsecured, commercial Fixed Income Indices paper is issued by investment-grade corporations or financial institutions for short- [email protected] term financial needs or to cover receivables. Notes maturing within 270 days from issuance are not subject to Securities and Exchange Commission (SEC) filings, thereby offering firms with high credit ratings cost-effective financing. Commercial paper is sold at a discount to creditors, who receive the par amount of the note at maturity. As of early January 2014, more than USD 1 trillion dollars of commercial paper was outstanding in the U.S. Asset-backed commercial paper (ABCP) once made up over 55% of the U.S. commercial paper market, but today it accounts for less than 24%. ABCP has declined dramatically since the 2008 market crash (see Exhibit 1). Traditional commercial paper is collateralized by a promissory note from an investment-grade corporation or institution, whereas ABCP could carry more risk in certain market conditions because it is secured by specified assets. Exhibit 1: Commercial Paper Outstanding (Seasonally Adjusted) 2,500,000 2,000,000 1,500,000 1,000,000 500,000 USD Millions Millions USD If the assets underlying ABCP become distressed, 0 risk-averse investors may reallocate funds to other cash-equivalent investments, July 2012 July July 2001 July 2002 July 2003 July 2004 July 2005 July 2006 July 2007 July 2008 July 2009 July 2010 July 2011 July 2013 July and the ABCP issuer may not January 2010 January January 2002 January 2003 January 2004 January 2005 January 2006 January 2007 January 2008 January 2009 January 2011 January 2012 January 2013 January 2014 be able to roll new issuance. January 2001 Asset-Backed Commercial Paper Outstanding Financial Commercial Paper Outstanding Nonfinancial Commercial Paper Outstanding Source: Federal Reserve. Data as of July 31, 2014. Chart is provided for illustrative purposes only. If the assets underlying ABCP become distressed, risk-averse investors may reallocate funds to other cash-equivalent investments, and the ABCP issuer may not be able to roll new issuance. Rules pertaining to certain ABCP require liquidation if certain conditions are not met, which has the potential to trigger several large programs to sell their depressed assets at the same time, further enhancing downward pricing pressure. When omitting ABCP from the current U.S. commercial Indexing Commercial Paper October 2014 paper market, assets have returned to 2005 levels (see Exhibit 2). Exhibit 2: U.S. Commercial Paper Market (ex-Asset-Backed Paper) 1,200,000 1,000,000 800,000 600,000 400,000 USD Millions USD 200,000 0 July 2001 July 2002 July 2003 July 2004 July 2005 July 2006 July 2007 July 2008 July 2009 July 2010 July 2011 July 2012 July 2013 July January 2011 January January 2002 January 2003 January 2004 January 2005 January 2006 January 2007 January 2008 January 2009 January 2010 January 2012 January 2013 January 2014 January The first commercial 2001 January Financial Commercial Paper Outstanding Nonfinancial Commercial Paper Outstanding paper index from a major independently managed Source: Federal Reserve. Data as of July 31, 2014. Chart is provided for illustrative purposes only. and governed index provider was the S&P S&P U.S. Commercial Paper Index U.S. Commercial Paper Index. The first commercial paper index from a major independently managed and governed index provider was the S&P U.S. Commercial Paper Index. The index comprises over 1,200 notes issued from the largest investment-grade firms, with maturities ranging from zero to three months (see Exhibit 3). Each issuer has a program that compiles up to 10 of the firm’s notes. Issuers must have a minimum program of USD 2 billion to be eligible for inclusion in the index. Issuers are evaluated on a semiannual basis and issued notes are rebalanced monthly. The S&P Commercial Paper Index requires ratings from one of the three leading agencies (Standard & Poor’s Rating Services, Moody’s or Fitch), and it excludes ABCP in an effort to maintain a certain level of credit quality. Exhibit 3: S&P U.S. Commercial Paper Index, Months to Maturity by Market Value 0-1 Month 1-2 Months Source: S&P Dow Jones Indices LLC. Data as of June 30, 2014. Chart is provided for illustrative purposes only. 2 Indexing Commercial Paper October 2014 Risk/Return Characteristics As an asset class, commercial paper has outperformed U.S. Treasury bills over the past one-, three- and five-year horizons. When comparing notes of matching maturities, the S&P U.S. Commercial Paper Index reflected a 0.31% five-year annualized return, while the S&P/BGCantor 0-3 Month U.S. Treasury Bill Index returned 0.07% (see Exhibit 4). Commercial paper demonstrates relatively Exhibit 4: Money Market Annualized Returns low volatility. 0.35% 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% S&P U.S. S&P U.S. S&P U.S. S&P/BGCantor 0-3 S&P/BGCantor Commercial Paper Commercial Paper Commercial Paper Month U.S. U.S. Treasury Bill Financials Index Index Non-Financials Treasury Bill Index Index Index 1-Year Return 3-Year Return 5-Year Return Source: S&P Dow Jones Indices LLC. Data as of June 30, 2014. Past performance is no guarantee of future results. Commercial paper has historically demonstrated relatively low volatility. Annualized risk data has shown a standard deviation of less than 0.02% over a five-year time period. The range of volatility is similar to that of U.S. Treasury bills (see Exhibit 5). Exhibit 5: Annualized Risk (Standard Deviation) Index 1-Year (%) 3-Year (%) 5-Year (%) S&P U.S. Commercial Paper Index 0.01 0.01 0.02 S&P U.S. Commercial Paper Financials Index 0.01 0.02 0.02 S&P U.S. Commercial Paper Non-Financials Index 0.01 0.01 0.02 S&P/BGCantor U.S. Treasury Bill Index 0.02 0.02 0.03 S&P/BGCantor 0-3 Month U.S. Treasury Bill Index 0.01 0.01 0.01 Source: S&P Dow Jones Indices LLC. Data as of Sept. 15, 2014. Past performance is no guarantee of future results. Correlation While the Federal Reserve used to trade commercial paper alongside the short-term U.S. Treasury bills, the two asset classes demonstrate low correlation. Comparing the S&P U.S. Commercial Paper Indices against the S&P/BGCantor Treasury Bill Indices shows this lack of correlation despite the similar volatility of the two series (see Exhibit 6). 3 Indexing Commercial Paper October 2014 Exhibit 6: Correlation Between S&P Commercial Paper Indices and S&P U.S. Treasury Bill Indices 0.90 0.70 0.50 0.30 0.10 Correlation StatisticCorrelation -0.10 -0.30 S&P U.S. S&P U.S. S&P U.S. S&P/BGCantor S&P/BGCantor S&P/BGCantor S&P/BGCantor S&P/BGCantor Commercial Commercial Commercial 0-3 Month U.S. 3-6 Month U.S. 6-9 Month U.S. 9-12 Month U.S. U.S. Treasury Paper Index Paper Paper Non- Treasury Bill Treasury Bill Treasury Bill Treasury Bill Bill Index Financials Index Financials Index Index Index Index Index 1-Year Correlation 3-Year Correlation 5-Year Correlation Source: S&P Dow Jones Indices LLC. Data as of June 30, 2014. Past performance is no guarantee of future results. Yields In the low-yield environment, yields on commercial paper dropped between 2012 and mid-year 2014. Yields edging up toward 0.22% in February of 2012 had a weighted average yield closer to 0.12% in July 2014 (see Exhibit 7). The paper-to-bill spread returned to prerecession lows by mid-2014 (see Exhibit 8). In the low-yield Exhibit 7: Weighted Monthly Yield-to-Worst environment, yields on 0.30 commercial paper dropped between 2012 and mid-year 2014. 0.25 0.20 0.15 0.10 0.05 S&P U.S. Commercial Paper Financials Index S&P U.S. Commercial Paper Index Source: S&P Dow Jones Indices LLC. Data as of July 15, 2014. Past performance is no guarantee of future results. 4 Indexing Commercial Paper October 2014 Exhibit 8: Paper-to-Bill Spread 5.000 4.500 4.000 3.500 3.000 2.500 Spread % Spread 2.000 1.500 1.000 0.500 0.000 Source: Federal Reserve Bank of St. Louis. Data as of June 30, 2014. Past performance is no guarantee of future results. Rollover risk is a key risk factor of Risks commercial paper. Commercial paper could demonstrate the following types of risk. Rollover Risk: Commercial paper is a rolling form of debt, so new issues typically refund those retiring, creating rollover risk. Rollover risk is a key risk factor of commercial paper. Taxable Interest Risk: Commercial paper continually rolls over and the interest earned is taxable. The more interest earned, the larger the tax obligation. Default Risk: Commercial paper is not insured by the FDIC or regulated by the SEC. The assets of the issuing corporation are not used to secure the commercial paper, which is unsecured debt (unless ABCP). While defaults are rare, the risk remains. Exhibit 9: Top Programs by Par Value Program Par Value (USD Thousands) Coca-Cola Company 3,100,795.22 Ford Motor Credit Company 3,002,636.39 Deutsche Bank Financial LLC 3,001,584.88 Credit Suisse Group AG 3,001,524.84 Bank of Tokyo-Mitsubishi UFJ New York 3,001,305.60 Mizuho Funding LLC 3,001,293.60 Abbey National North America LLC 3,001,278.59 BNP Paribas Finance, Inc.