July 16 (Bloomberg) -- The U.S. commercial paper market, the cheapest source of corporate cash, is shrinking at a record pace, raising the cost of capital for borrowers from Consolidated Edison Inc. to Kellogg Co.

The market for company debt due within nine months has plunged 28 percent since April 8 to $1.1 trillion, its longest and deepest slump, Federal Reserve data show. Investor demand for all but top-rated commercial paper, or CP, evaporated after September’s collapse of the $62.5 billion Reserve Primary Fund sparked a run on money-market accounts, and as the recession sapped companies’ need for short-term credit to expand.

Proposals from the U.S. Securities and Exchange Commission in June may worsen the slump by restricting money-market funds, which hold 40 percent of the paper, to only top-rated debt. That would force more companies to sell bonds that may cost an extra 8 percentage points in interest, or $8 million a year for every $100 million borrowed.

“You’re not going to build that plant, you’re not going to expand, you’re not going to hire folks,” said Brian Kalish, a director at the Association for Financial Professionals, which represents 16,000 corporate treasurers, bankers and investors. “We’re creating this world of haves and have nots.”

Higher corporate interest costs may slow the economic recovery, Kalish said in an interview from his Bethesda, Maryland, office. The U.S. economy, after contracting 6.3 percent in the fourth quarter and 5.5 percent in the first, is forecast to start growing in the third, according to the median estimate of 72 economists surveyed by Bloomberg.

Higher Rates

For now, companies are willing to pay higher rates to ensure access to capital after watching credit dry up almost overnight as the subprime mortgage contagion spread in 2007 and 2008 and Lehman Brothers Holdings Inc. collapsed in September.

More than 60 companies sold bonds this year to repay commercial paper, including Consolidated Edison, Verizon Communications Inc. in New York and Kellogg, the 103-year-old maker of Keebler cookies and Rice Krispies cereal, according to data compiled by Bloomberg. Non-financial companies have sold $306 billion of investment-grade bonds this year, a record pace.

“Treasurers aren’t sleeping at night because they don’t know if they can roll over commercial paper,” said Anthony J. Carfang, a partner at Treasury Strategies Inc, a Chicago consulting firm. “They’d rather lock in money for five years and pay a little more.”

ConEd Cuts

Con Edison, New York City’s biggest utility, sold $750 million in 5- and 10-year notes on March 23 to yield as much as 6.67 percent, more than 6 percentage points above the average rate on commercial paper the company retired, according to a March 24 regulatory filing. Con Edison has cut its CP borrowings to $300 million, from $1 billion in March 2008.

“We went through the problems last fall when things tightened considerably,” said James O’Brien, treasurer of New York-based Con Edison. “I don’t know that we would carry our paper balances as high as we did in the past.”

The higher costs have so far not affected the company’s capital expenditures, which were reduced by $200 million this year to $2.3 billion because of slower economic growth, he said.

The commercial paper market was roiled when the Reserve Primary Fund, based in New York and opened by Bruce R. Bent’s Reserve Management Co. in 1971, fell below the standard $1 a share, or broke the buck, on Sept. 16 because of losses on Lehman debt a day after the investment bank declared bankruptcy. The fund held $785 million, or 1.3 percent of its assets, in Lehman CP and floating-rate notes.

Pulling Out

Investors pulled $744 billion from prime money funds over the following three weeks, and so-called second-tier 30-day commercial paper rates doubled to 6.02 percent within two days. Corporations couldn’t issue short-term debt as the funds stopped buying new issues. The Reserve Fund is being liquidated.

The SEC wants to make the $3.62 trillion money-market industry safer by preventing the funds from holding debt sold by second-tier companies, or those with investment-grade ratings one level below what is considered the top, such as Con Edison.

The Investment Company Institute, an industry trade group in Washington, proposed in March to prohibit money funds from purchasing second-tier debt, ranked A-2 by Standard & Poor’s, P- 2 by Moody’s Investors Service or F2 by Fitch Ratings. The group also said money funds should keep minimum levels of liquid assets on hand and hold debt with shorter average maturities -- changes that would limit demand for commercial paper.

Federated, JPMorgan

Ten funds that helped draft the proposals, including those run by Pittsburgh-based Federated Investors Inc. and New York- based JPMorgan Chase & Co., plan to adopt them voluntarily, said Jack Brennan, chairman of Vanguard Group Inc. in Valley Forge, Pennsylvania, and head of the panel that drafted the recommendations.

The SEC followed in June with similar recommendations that included even shorter maturity restrictions and higher minimum cash levels. In the year ended July 10, prime money funds reduced their commercial paper to 39 percent of all assets, from 45 percent, and increased Treasuries and other government-backed debt to 17 percent, from 6 percent, according to IMoneyNet Inc. in Westborough, Massachusetts.

Commercial paper outstanding fell $39.7 billion, or 3.5 percent, during the week ended yesterday, its 14th straight decline, the Fed said today. At $1.097 trillion, the CP market is less than half its peak of $2.22 trillion in July 2007, with about 10 percent of it owned by the Fed, central bank data show.

The market for second-tier CP also has also shrunk by almost half to $44.1 billion since August 2007, with daily issuance down to $2.66 billion in June, the least in more than a decade and a third of what was sold a year earlier, Fed data show.

‘Alternate Sources’

“The CP market, particularly for 2-rated issuers, has been less reliable since the credit crisis occurred,” said Brad Fox, chairman of the National Association of Corporate Treasurers, who holds that job for supermarket chain Safeway Inc. in Pleasanton, California. Second-tier companies are “trying to increase their liquidity through alternate sources,” he said.

Markets may be coming back after the Federal Reserve and President Barack Obama pledged $12.8 trillion to pull the economy out of the worst calamity since the 1930s. All but $81.3 billion has flowed back into prime funds.

“The commercial paper market has had many cycles over the years, so I think it will come back,” Fox said. “It’s an extremely attractive way for corporations to manage their cash flow requirements and daily reconciliations, by far the most efficient way to do it rather than borrow from your banks.”

Duke’s Strategy

Duke Energy Corp., owner of utilities in the Carolinas and the Midwest, has had less trouble issuing commercial paper than some issuers because it had a diversified buyer base, assistant treasurer Donna Council said in an interview. The Charlotte, North Carolina company, with second-tier ratings from S&P and Moody’s, sells directly to lenders that include insurance companies, banks and pension funds. Money funds own less than 1 percent of its commercial paper, Council said.

“Issuers need to focus on developing more diverse sources of funding, rather than just relying on an investor class that will run for cover when credit conditions deteriorate,” David Glocke, who helps manage $203 billion in money-fund assets as head of taxable money-market investments at Vanguard Group Inc. in Valley Forge, Pennsylvania.

Kellogg raised $750 million on May 18 from a seven-year bond offering to repay commercial paper and “maintain liquidity in this difficult environment,” Chief Executive Officer David Mackay said at the Deutsche Bank Global Consumer & Food Retail Conference in Paris on June 9. Company officials declined to comment further.

Kellogg Yields

The largest U.S. cereal maker, deemed second tier by the three biggest ratings companies, agreed to pay yields of 4.49 percent, almost four times higher than the 1.19 percent mean rate on its commercial paper, the Battle Creek, Michigan-based company said in a May 19 SEC filing.

“Clearly we would be concerned about liquidity and about the ability of investors to buy our paper” if the SEC’s proposals are adopted, said Chuck Zebula, treasurer at Columbus, Ohio-based American Electric Power Co. Cutting second-tier borrowers off from federal aid and money-market funds “starts to disadvantage an important part of the economy,” he said.

American Electric, which delivers electricity to more than five million customers in 11 states, borrowed about $2 billion last fall under two revolving credit facilities to pay off about $400 million of commercial paper and bolster its cash reserves, according to the company.

While the company is issuing commercial paper “actively,” the higher cost of capital has translated into higher electricity rates for customers, Zebula said.

To contact the reporters on this story: Bryan Keogh in New York at bkeogh4@bloomberg.netChristopher Condon in Boston at ccondon4@bloomberg.net

Last Updated: July 16, 2009 13:19 EDT