In what some fund managers say reinforces their concern with an emerging short-term investment product, Standard & Poor's is calling into question the potential liquidity of a new type of commercial note that allows issuers to unilaterally extend the maturity.
Known as an extendible commercial note, the product was introduced in the taxable short-term market last year and pushed by bankers at Goldman, Sachs & Co. Outstanding corporate issuance stands at $14 billion, according to Goldman, and two municipal issuers have jumped on the bandwagon. In the municipal market, $325 million of debt with the structure has sold and officials at Standard and Poor's say two new issues are in the works.
But some analysts question how the notes are being priced and worry that money market funds might have problems unloading them if issuers exercise their option to extend the maturity.
Specifically, money market funds are being told to designate the notes as part of the illiquid portion of their portfolios.
"Money market funds are supposed to be the most liquid portfolio," said Joel Friedman, an analyst at Standard & Poor's in the rated funds group. "We're not trying to scare the market. We're just telling the money market funds that these are the things that we are looking at."
For some in the money market, the report confirms what they say is a hesitancy to buy the product. Walter Beveridge, a money market fund manager at Charles Schwab & Co. in San Francisco, said he has not bought the new notes because the extension option effectively takes control of his portfolio out of his hands.
"Anything that takes the ability out of the portfolio manager's hands," Beveridge cautioned, "I would be concerned about that."
With extendible commercial notes, a borrower who doesn't have the money to retire the outstanding paper at the maturity date can simply choose to extend the due date, forcing portfolio managers to extend the maturity and keeping the notes in their portfolio for as long as 390 days.
The funds, or other holders of the notes, are in effect providing the line of credit that, for traditional commercial paper programs, comes from a bank backing the issue, analysts note.
In the case of what are known as ECNs in the taxable market and extendable maturity commercial paper, or EMCPs, in the tax-exempt market, the borrower does not get a bank line of credit. Rather, the borrower comes to market on its own short-term credit standing.
Because issuers can forgo credit enhancement, the programs have great appeal to issuers, who can save about six basis points on their commercial paper issues by not having to secure bank backing. Issuers also say the structure saves them administrative headaches.
While Standard & Poor's analysts say that the extendible option does not have to be calculated in the weighted average maturity of portfolios, many in the municipal market are, like Beveridge, circumspect on the matter.
"I don't run my funds with something like that sticking out there," said Michael Carbuto, portfolio manager at OppenheimerFunds Inc. "The issues I had with these initially are resurfacing," he added, referring to the Standard and Poor's report. "It's not anything new, but it's given me additional reason not to buy them."
Of course, Wisconsin and Shelby County, Tenn., have been able to sell a total of $325 million in EMCPs, indicating there is a market for the product. A banker at Goldman would not comment on the product, but Standard & Poor's reports that 40% of the $14 billion in outstanding ECN and EMCP debt is held by money market funds.
Some market players point to the larger fund groups, with their extensive research strengths, as potential buyers. Others say that institutional investors such as corporations or pension funds may also be buyers.
Like the bankers, both Wisconsin and Shelby County are tightlipped on who is buying the debt.
At Fidelity Investments, municipal money market fund manager Scott Orr, who would not confirm that his firm is a buyer, said he is well aware of the new notes.
"In general, they do fit the Securities and Exchange Commission rules," Orr said. "It's just how you view them, how appropriate they are for your strategy. You have to go into it with an idea of how to manage it. It's not a typical piece of paper."
While it may not be typical, other developments suggest the notes could find market acceptance. One key to that, market watchers say, is that Goldman did not make the structure proprietary, meaning that any investment bank can copy it.
Banks already duplicate successful products, but, in this case, Goldman is not limiting copycat programs. Rating agency analysts say that, on the taxable side, Merrill Lynch & Co. has structured and sold the notes.
On the tax-exempt side, Wisconsin is doing its part to push the product on the market by requesting that the other firms besides Goldman that underwrite its commercial paper -- including Bear, Stearns & Co., Lehman Brothers, and Merrill -- set up similar programs.
"From our standpoint, we would like to see the idea grow," said Frank Hoadley, the state's director of capital finance. "As it grows, it's to our advantage, because there will be more liquidity."
Wisconsin was the first to sell extendible notes in the municipal market, issuing $50 million in September. Hoadley said the pricing came right on top of market rates for standard commercial notes sold around that time. Wisconsin sold the notes at maturities between 27 and 180 days and got yields of 3.45% on the short end and 3.65% on the long end.
The presumption in the market is that institutions buying the notes can expect a five basis point premium for taking on the line of credit risk. But Hoadley said the market is always moving, and it remains difficult to judge the exact premium being paid by borrowers.
Wisconsin has since come to market with another $75 million, and Shelby County sold $200 million last month through Goldman. The extension option for Wisconsin is 90 days, while Shelby has a 180-day option.
While the pricing plays out, analysts at Standard & Poor's are looking at the impact of extendible notes on the commercial paper programs that it rates -- not just the impact on rated funds. This week, for instance, public finance analysts released a report summarizing the developments in the municipal market.
In a move that could have implications for the tax-exempt market, meanwhile, corporate rating analysts have said they are revising their methodology for rating commercial paper programs, in part because of the changes that extendible notes have introduced.
A Standard & Poor's corporate analyst, Solomon Samson, said the agency is shifting its focus away from 100% bank back-up for the short-term rating portion of a commercial paper program and is looking more at the overall maturities outstanding among the notes. This makes sense, Samson said, because the addition of extendible notes to a commercial paper program reduces the percent of bank back-up.
The agency's public finance analysts said they still require 100% back-up, and, to some extent, played down the methodology changes for corporate ratings.
"Right now, it's going to be a case by case basis," said Hyman Grossman, managing director in the public finance group.
Diane Brosen, a director who covers short-term debt, said "a lot of it depends on how the investors respond."
