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Short-Term Funding for Nonfinancial Corporations. A nonfinancial company usually raises external funds for investment in short-term assets (cash, short-term investments, accounts receivable, and inventory) through financial intermediaries that provide either loan financing or security-based financing.

External loan financing, or bank lines of credit, refers to agreements between borrowers and banks to draw down funds as required. These primarily consist of three types — uncommitted, committed, or revolving lines of credit:

1. Type 1:Uncommitted line of credit. A bank extends an offer of credit for a principal amount, usually charging a floating market reference rate (MRR) plus a fixed credit spread on funds drawn down. The bank may refuse to lend if circumstances change, so this is a less reliable source of funds. However, it is flexible with no fees outside of interest charges. Can be unsecured if the borrower maintains stable cash balances with the bank.
2. Type 2:Committed (regular) line of credit. Bank commits to an offer of credit for a specific time period — more reliable than uncommitted. Banks charge a commitment fee (typically about 50 bps) on either the full or unused amount over the commitment period. Regulators require banks to hold higher reserves on committed lines. Banks may withdraw the agreement at maturity should credit conditions worsen, leading to renewal risk.
3. Type 3:Revolving (operating) line of credit. The most reliable form. "Revolvers" are typically for a longer term, sometimes years (with potential medium-term loan facilities). Banks place restrictive covenants on borrowers. Fees and rates are similar to a committed line of credit.

Companies with weaker credit ratings typically must pledge assets as collateral. Secured (asset-backed) loans are backed by collateral (fixed assets, receivables, inventory). Companies can assign receivables as collateral. Factoring refers to the actual transfer of credit granting and collection of receivables to a lender ("factor") at a discount from face value. The discount represents the interest rate, depending on customer creditworthiness and collection costs.

External Security-Based Financing. Large corporations with high credit ratings can reduce funding costs by issuing short-term unsecured debt securities, referred to as commercial paper (CP). For these firms, the interest cost of CP is less than the interest on a bank loan. With maturity typically less than three months, CP is issued to fund working capital and as a temporary source of funds before issuing longer-term debt. Debt that is temporary until permanent financing can be secured is referred to as bridge financing.

CP is often reissued, or "rolled over," when it matures. The risk that a company will not be able to sell new CP to replace maturing paper is termed rollover risk. To manage this risk, borrowers maintain backup lines of credit with banks (sometimes called liquidity enhancement or backup liquidity lines), where lenders agree to provide funds to repay maturing CP if needed.

Similar to U.S. T-bills, CP in the United States is typically issued as a pure-discount security, making a single payment equal to face value at maturity. A smaller, less liquid international market in CP also exists, referred to as Eurocommercial paper (ECP).

Short-Term Funding for Financial Institutions. Commercial and retail deposits are a major short-term funding source for banks.

• Checking accounts ("demand deposits") provide transaction services and immediate availability of funds but typically pay no interest.
• Operational deposits are made by larger customers who require cash management, custody, and clearing services.
• Savings deposits have a stated term and interest rate. These may take the form of an interest-bearing certificate of deposit (CD):
  • Nonnegotiable CDs cannot be sold before maturity; early withdrawal incurs a penalty.
  • Negotiable CDs can be sold in the open market before maturity. At the wholesale (institutional) level, negotiable CDs are an important funding source for banks. They trade in domestic bond markets as well as in the Eurobond market.

Interbank funds are loaned by one bank to another, for periods of one day to a year, on either a secured or unsecured basis, at an interest rate based on a market reference rate (MRR) that varies across markets. The most common type of secured interbank borrowing is carried out through repurchase agreements (repos).

Central bank funds market. Banks in most countries must maintain a portion of funds as reserves on deposit with the central bank. Banks with excess reserves lend them to banks that need funds at the central bank funds rate, which is strongly influenced by the central bank's open market operations and by the availability of short-term funds. The central bank may act as the lender of last resort ("discount window lending") to banks struggling to access liquidity, typically at a higher rate than the central bank funds rate, possibly with extra scrutiny and restrictions on the borrower.

Asset-backed commercial paper (ABCP). Financial institutions issue more CP than nonfinancial companies and often sponsor ABCP, a short-term asset-backed security. The creation process:

1. A financial institution transfers collateral (usually existing short-term loans) to a separate legal entity called a special purpose entity (SPE), in return for cash. The SPE is set up as an off-balance-sheet vehicle.
2. The SPE sells ABCP to investors, who accept the risk and return of the collateral. The sponsoring institution provides a backup credit liquidity line.

A repurchase agreement (repo) is an arrangement by which one party sells a security to a counterparty with a commitment to buy it back at a later date at a prespecified higher price. The original purchase price is effectively a loan by the security buyer to the security seller, with the security as collateral. The difference between the repurchase price and the original purchase price represents the interest paid to the security buyer; the annualized interest rate implied by the difference is called the repo rate.

To protect the lender against a decrease in collateral value, the borrower posts extra collateral above the loan amount by an amount known as the initial margin. The loan amount is therefore a discount to the value of the securities.

Example. A firm enters a repo to sell a bond today (market value $1,000,000) and repurchase it 90 days later. Repo rate = 2%; initial margin = 103%.

Initial purchase price (loan amount):

\( \displaystyle \text{Purchase price} = \frac{\text{Market value}}{\text{Initial margin}} = \frac{\$1{,}000{,}000}{1.03} = \$970{,}874 \)

Repurchase price after 90 days (360-day convention):

\( \displaystyle \text{Repurchase price} = \$970{,}874 \times \left[1 + \left(0.02 \times \frac{90}{360}\right)\right] = \$975{,}728 \)

The discount applied to the market value of collateral is referred to as a haircut:

\( \displaystyle \text{Haircut} = \frac{\$1{,}000{,}000 - \$970{,}874}{\$1{,}000{,}000} = 2.91\% \)

Equivalently: \( \displaystyle \text{Haircut} = 1 - \frac{1}{\text{Initial margin}} \).

The loan value increases during its life at the repo rate. Should the market value of the collateral fall below this value times the initial margin, the lender will ask the borrower for more collateral, known as variation margin.

Example (continued). Assume that after 30 days the market value of the bond has fallen to $990,000.

Adjusted loan amount after 30 days:

\( \displaystyle \$970{,}874 \times \left[1 + \left(0.02 \times \frac{30}{360}\right)\right] = \$972{,}492 \)

Required collateral value = \( \$972{,}492 \times 1.03 = \$1{,}001{,}667 \). Because the actual collateral value ($990,000) is less, the borrower must provide variation margin:

\( \displaystyle \text{Variation margin} = (\text{Initial margin} \times \text{Adjusted purchase price}) - \text{Market value of collateral} \)

\( = \$1{,}001{,}667 - \$990{,}000 = \$11{,}667 \)

The lender will ask the borrower to post an extra $11,667 of securities. If the variation margin is negative, the loan is overcollateralized and the borrower can request a release of collateral equal to the variation margin amount.

A repo for one day is an overnight repo; a longer agreement is a term repo. Because of the short-term, collateralized nature (often high-quality sovereign bonds), repo rates are customarily lower than rates on bank loans or other short-term borrowing. Although described as a "sale" and "repurchase," the seller/borrower retains rights to the benefits of holding the bond over the repo term. Collateral may be a specific security or a general type of security (e.g., Treasury bonds within a maturity range), in which case it is a general collateral repo. Contractual terms are contained in the master repurchase agreement.

Repo Applications. The main uses of repurchase agreements are:

• Financial institutions enter repos as security sellers/borrowers to finance positions in securities held in their trading activities.
• Banks and institutional investors (mutual funds, pension funds) enter repos as security buyers/lenders to earn the repo rate on excess short-term funds.
• Central banks may use repos to enact monetary policy — buying securities/lending to increase the money supply, and selling securities/borrowing to decrease the money supply.
• Short sellers (e.g., hedge funds) can use repos to borrow securities they intend to short sell, speculating that value will decrease. Trade sequence:
  1. Buy securities/lend in a repo.
  2. Short sell the securities in the open market.
  3. Buy back the securities in the open market later (before the repo term ends).
  4. Deliver the securities back to the repo counterparty at maturity.
  The hedge fund earns the repo rate as lender and gains if the security value decreases over the repo term. When the motivation is to borrow a specific security in this way, the participant is said to be entering a reverse repo.

A short seller will need to specify the security they wish to borrow (a special trade). If the specified security is hard to borrow, the hedge fund will accept a lower repo rate than that earned on general collateral, or possibly a negative repo rate for extremely-hard-to-source collateral.

Factors Affecting the Repo Rate. The repo rate is usually:

• Higher, when interest rates for alternative sources of short-term (money market) funds are higher.
• Lower, the higher the credit quality of the collateral security.
• Higher, the longer the repo term (when longer-term rates are generally higher than short-term rates).
• Lower, when the collateral security is in high demand or low supply.
• Higher, if the repo is undercollateralized, or if collateral is specified but not actually delivered to the lender.

Repo Risks. A repo is a safer form of lending than most short-term sources, but it is still debt financing — overuse can lead to financial distress or insolvency. Major risks include:

• Default risk — the lender of the security (borrower of cash) fails to make the repurchase payment at the end of the repo.
• Collateral risk — relating to the value that can be generated for collateral in event of default.
• Margining risk — relating to the timely and accurate calculation and payment of margin.
• Legal risk — that the contracts cannot be legally enforced.
• Netting and settlement risk — relating to the ability to net off payments across different contracts with the same nondefaulting counterparty, and the ability to settle the cash and collateral transactions underlying the repo.

Many of these risks can be mitigated through tri-party repos, which employ a third-party intermediary (usually a custodian bank or clearinghouse) as agent to arrange and administer repo transactions. While this does not reduce credit risk, it likely improves cost efficiencies regarding access to collateral and counterparties, and the valuation and safekeeping of assets. A repo struck directly between two parties without a third party is referred to as a bilateral repo.

In a normal yield curve environment, bond yields are higher for longer-dated maturities. Both investment-grade (IG) and high-yield (HY) issuers must offer higher yields on longer-maturity issues; however, this difference across maturity is greater for HY issuers due to higher spreads. Companies that issue shorter-dated bonds to reduce yield assume rollover risk.

Other major differences between IG and HY debt issuance:

• Default risk and loss given default are primary concerns for HY investors, due to lower issuer credit quality. For IG investors, the primary credit-related concern is the chance of a ratings downgrade and increased probability of future default, rather than imminent default.
• Credit spreads are likely to be a smaller proportion of yield for IG issues, where yields are largely tied to benchmark rates (e.g., sovereign debt).
• Covenants: IG issuers usually face only a few restrictive covenants — typically limiting liens and sale-and-leaseback arrangements on core operating assets. HY issuers face more covenants relating to debt-based ratios, additional debt issuance, and distributions of capital to equity investors (e.g., dividend limits). HY issuers are also likely to need to provide collateral.
• Standardization and maturity: IG issues are somewhat standardized and typically issued across multiple maturities, reducing rollover risk and allowing IG issuers to take advantage of changing market conditions. HY issues have more specific covenants and liens, are less standardized, and are usually issued with maturities of 10 years or less — less able to refinance when borrowing costs fall.
• Prepayment / call features: HY issuers are more likely to structure debt that can be repaid earlier if credit quality improves, either via leveraged loans with prepayment options or callable debt.
• Return profile: Due to higher cash-flow uncertainty, HY returns are likely to be more equity-like than IG returns.