A Frightful Outlook for Financing

Boo! That's what investors who operate on the short end of the yield curve have been saying all year, and issuers have been fleeing the sector in fright. While some might find the topic dry, financing has tremendous implications for companies and the economy.

Earlier this year, I noted the forces that were causing money-fund assets to soar. I cringed when I saw news reports screaming last spring that nearly $2 trillion in money market funds was just waiting to flood the stock market. This money flowing into funds was simply an arbitrage game, with institutions that normally bought instruments directly switching to the higher yields that money funds offer in a declining yield environment.

The Commercial Paper Situation

Many of these institutions often bought lower-rated commercial paper. When they switched to funds, the demand for this paper was reduced because funds are allowed to buy only a little of it, and most funds buy none. As a result, many lower-rated issuers were finding themselves shut out of the market.

Given the decline in credit quality this year, many other issuers, such as WorldCom (WCOM Quote) started worrying that commercial-paper buyers would cut off their liquidity. These issuers cut back the amount of money they borrowed in the short-term markets and issued longer-term bonds instead. These proved to be smart moves. The shift to more stable funding may not have lifted these companies' stock prices, but it precluded any liquidity worries that firms with declining credit quality and heavy short-term borrowings, such as Motorola (MOT Quote) and AT&T (T Quote), have suffered this year.

This shift away from short-term borrowing has produced a stunning decline in the size of the commercial paper market this year.

Non-Financial Commercial Paper Year-to-Year % change in amount outstanding

Source: Federal Reserve Board of St. Louis

Since Sept. 11, these trends have intensified. The attacks further worsened the outlook for corporate credit quality. Corporate yield spreads have widened, and though the Federal Reserve brought short-term yields down by another 100 basis points, long-term corporate-bond yields have risen, at least through Wednesday's announcement that the Treasury will cease issuing 30-year bonds. This news produced a sharp drop in long Treasury yields; hopefully corporates will be able to follow suit.

Rough Road Ahead

I've noted that we're nearing the time of year when financing normally becomes difficult. This year is shaping up to be especially ugly.

While many mutual funds have October fiscal years, most institutional investing is reported on a calendar-year basis, and few short-term investors want to show anything even remotely risky at year-end. Until 1998, the spread between Tier-1 commercial paper (short-term ratings of A1 and P1 from S&P and Moody's) and Tier-2 commercial paper (rated A2 and P2) would normally rise from 20 basis points to about 40 by November. It then would fall right back down once the new year started.

In 1998, though, this spread gapped out to about 90 basis points at year-end in the wake of the Asian crisis. In advance of Y2K, this spread jumped out to more than 100. During last year's financing mess, it went above 140. It started to come down normally last January, but the magnitude of the Fed's rate cuts set the arbitrage in motion, and this kept the spread wide for much of this year.

This spread got back to normal this August, but it has since widened significantly.

Commercial-Paper Quality Spread Tier-2 Paper over Tier-1 Paper, in basis points

Source: Federal Reserve

Since September there has been a new rush of institutions into money funds, further squeezing issuers. Measured by this quality spread, the year-end financing situation has never been this bad this far away from year-end. This situation has had ramifications not only on the money markets but also throughout the entire fixed-income arena.

First, plenty of liquidity exists for those who don't need it. Brian Yeazel, a chartered financial analyst and director at Northwestern Mutual in Milwaukee, points out that the combination of huge inflows and a shrinking supply of commercial paper means that many money market funds are having trouble finding enough quality credits to buy. He notes that money funds have been turning to asset-backed commercial paper as an alternative but, given the relatively few asset types that are being securitized, this can continue for only so long before funds bump up against diversification requirements.

Top-quality firms that want to extend maturities a bit have no problem doing so and can issue debt at incredibly low rates. Last week, Pfizer (PFE Quote) was able to issue three-year notes at 3.63%.

Second, firms fearful of losing access to the commercial-paper markets are being forced to pay up in order to assure funding. Instead of paying 2.5% or so for commercial paper, General Motors (GM Quote) and Ford (F Quote) have had to reduce their short-term borrowings and go out along the curve. GM had to pay 7.36% on the 10-year part of its issue, an increase of about 40 basis points above where that issue had originally been priced on Sept. 5.

Third, it has formed distinct levels of tiering in financial markets. GM and Ford, now Tier-2 issuers, will still issue commercial paper to the few remaining buyers. These automakers have a history of managing downturns, so they're viewed as "safe" Tier-2 issuers. With names like that now in the realm of second-tier issuers, investors have little reason to buy paper from riskier Tier-2 issuers such as Enron (ENE Quote), which is why that firm had to draw down all its bank credit lines.

Worrying About the Future

Meanwhile, the staggering amount of bids that Ford and GMAC drew for their bond offerings makes it look like there's a lot of liquidity, but that's misleading. Few bond deals happened after Sept. 11, so some pent-up demand existed for large deals. But I've also heard that there were so many bids partly because the deals were priced at such wide spreads that customary high-yield buyers were sniffing at them. The corporate-bond market remains illiquid and thin; when I ask my contacts what it's like to trade bonds now, the responses I get are mostly unprintable. That's why I applaud any action by the Treasury Department that would encourage lower long-term yields.

The tiering extends to the high-yield market as well. When you see high-yield types looking at Ford, you know they've become risk-averse. William Seibold of Galboca Partners, a Greenwich, Conn.-based hedge fund specializing in distressed debt, is "seeing pockets of overbuying in the 'safe' credits," while bonds that are "distressed or near distress have been pushed to extremely wide levels."

Now, bond investors are noted worriers. The stock market's recent recovery offers some hope that the economy will recover shortly, in which case credit-quality concerns would mitigate. I've been pointing out that the corporate market has been pricing in a much harsher economic outcome than the stock market has. Retail investors might also pump money into bonds and help ease the funding situation.

I hope the more optimistic scenarios play out. Otherwise, firms that have heavy short-term borrowings or need financing to survive will continue to have to pay up or not have access to financing at all. It's never pretty when the bond market separates the winners from the losers.