There Goes the Cheap Money

In Enron's wake, borrowers turn from commercial paper to longer-term debt

Eastman Chemical Co. (EMN ) may not be a household name, but as the credit flowed freely on Wall Street, the Kingsport (Tenn.) maker of specialty chemicals was able to borrow for a song. Last May, when the Eastman Kodak Co. (EK ) spin-off acquired a rival's resins business, the company covered the $244 million purchase mostly by issuing commercial paper--30-day, renewable notes with a mere 2.5% interest rate. And although Eastman originally planned to replace the paper with longer-term debt, management became loath to give up that great rate. Instead, it just rolled the notes over every month.

But with the spate of big-name bankruptcies and accounting scandals sending tremors through the credit markets, Eastman's chief financial officer, Albert J. Wargo, moved recently to change that. He traded in $400 million of Eastman's short-term borrowing for longer-term notes costing 7%. While the move will cut a hefty $18 million out of Eastman's pretax profits this year, Wargo takes solace that rates remain historically low. "The short-term markets are not as stable as they used to be," he sighs. "I'm willing to suffer a little pain right now because at some point in the future, rates will be higher."

Wargo has plenty of company. Since the fall, Moody's Investors Service, Standard & Poor's, and other rating agencies have applied tougher scrutiny to corporate balance sheets--effectively pushing many borrowers out of the volatile short-term lending market. At the same time, the prospect of economic recovery has convinced most execs that a rise in interest rates is inevitable. The combination has sent chief financial officers throughout Corporate America scrambling to shore up balance sheets with more stable debt and lock in today's low rates while they can. The latest to go long: AOL Time Warner Inc. (AOL ), which on Apr. 3 sold $6 billion in bonds, largely to reduce its short-term obligations.

The massive shift has sent the value of outstanding commercial paper of nonfinancial companies in the U.S. falling sharply: From a peak of $315 billion in November, 2000, it has dropped to some $172 billion today. Analysts expect it could contract further in coming months. And another corporate blowup could cause the commercial paper market to dry up even more. "If the commercial paper market were to shut down, AOL and lots of other companies could have real problems," says Philip Olesen, a fixed-income analyst at UBS Warburg.

The trouble is, bolstering the balance sheet with more stable debt comes at a considerable expense. With the equity markets largely closed to issuers and with bankers tightening credit as well, many borrowers are issuing long-term bonds at rates that are double, or even triple, what they were paying on the short end. Louise Purtle, head of U.S. credit strategy at CreditSights, a New York research firm, estimates that General Electric Capital Corp.'s recent sale of $11 billion of longer-term bonds in order to begin scaling back its massive $100 billion exposure to the commercial paper market will raise its borrowing costs by as much as $100 million this year alone. Analysts estimate that similar shifts on the part of AOL and Verizon Communications (VZ ) could raise those companies' borrowing costs by $300 million and $100 million, respectively. That could trim about 3% off of AOL's earnings this year and trim Verizon's by 1%.

Add that up for every company making the switch, and the collective toll on corporate profits--and the U.S. economy--could be huge. David Wyss, chief economist at S&P, estimates that the shift out of commercial paper and into bonds could raise Corporate America's borrowing costs overall by as much as $30 billion this year.

While that's just a fraction of the $752 billion in pretax profits that Corporate America earned last year, it's still enough to shave as much as two-tenths of a percentage point off of gross domestic product this year. And that means plenty of money that might otherwise have gone into capital spending, new product development, or marketing will be diverted to debt payments. "It's just one more nick against the recovery," says Wyss.

Of course, the sudden rush into bonds illustrates just how many companies let their balance sheets get out of whack in the 1990s. Many companies quietly used commercial paper to slash borrowing costs and bolster sagging profits. Indeed, new commercial paper borrowing equaled roughly 18% of nonfinancial corporate long-term borrowing in 2000, about twice the level of 1995.

There's a simple reason why. With short maturities--from 1 to 270 days--commercial paper was originally intended to help cover short-term funding needs such as payrolls. But when the annualized interest cost for commercial paper fell as low as 1.75% in the late 1990s, many companies began using it to finance longer-term projects such as constructing new factories.

But while it's cheap, commercial paper is an inherently risky form of borrowing. If questions of financial health arise, a company may find itself unable to roll over short-term notes. The reason: Securities & Exchange Commission regulations require that money-market funds--the main buyers of commercial paper--keep at least 95% of their assets in the highest-grade commercial paper. As a result, companies such as Tyco International Ltd. (TYC ) and Kmart Corp. (KM ) were suddenly shut out of the commercial paper market when they were downgraded by the rating agencies. The ensuing liquidity squeeze was a big reason the latter was forced to file for Chapter 11 on Jan. 22. "Investors in commercial paper have zero tolerance for credit risk," says Jack Malvey, chief global fixed-income strategist at Lehman Brothers Inc.

Despite the higher costs, many managements say that there is a bright side to debt rejiggering. Thanks to 11 Federal Reserve rate cuts last year, investment-grade companies can still borrow at just above 6%--a fraction of the 11% rate those same borrowers would have paid coming out of the 1991 recession. To every debt cloud, a silver lining.

By Dean Foust in Atlanta and Margaret Popper in New York, with Amy Barrett in Philadelphia, Peter Elstrom in New York, and bureau reports

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